... the regulatory capital has usually been perceived as too mechanical. Also, it seems that the risk buckets employed by it have made only ... developed by external agencies in order to assess the quality of their individual obligors. Thus, if under the old guidelines, claims ...
Story - puput - 10/04/2010 - 07:22 - 0 comments - 0 attachments
Pricing securities and risky income streams by no arbitrage arguments has become the corner stone of modern asset pricing theory. No arbitrage arguments have also been an impressive practical success. The valuation techniques derived from them have become the daily tools and workhorses of thousands of practitioners and financial engineers worldwide. The idea of no arbitrage is simple. It requires that correctly priced securities should make it impossible to achieve by financial transactions a consumption bundle at zero costs that increases some investor,s utility. This idea ultimately relies on an equilibrium argument and has powerful implications for asset pricing formulas. A great deal of this power comes from the fact that the question whether or not security prices do allow arbitrage, can be inferred from observable data: the prices of actively traded securities and their payoff structure. We do not have to know the entire equilibrium. Moreover once the correct security prices have been found, the price of any risky income stream which can be generated by combinations of these securities is determined. Thus security pricing by no arbitrage leads to a general valuation technique for arbitrary contingent claims, which can be generated from securities traded on financial markets.
Yet the formulas are derived under highly idealized conditions. Among them, perfect competition and frictionless security trading are the two most important ones. Evidence as well as practical experience suggests that the assumption of price taking behavior is to a large extent fairly appropriate for financial markets for standard securities, such as options, futures, stocks and bonds. The assumption of frictionless trading however is surely inappropriate. Margin requirements, short selling restrictions, borrowing constraints and collateral requirements belong to the basic facts of (financial) life, even for the most competitive financial markets.
What is meant by “argue?” The above subtitle is a deliberate play on two meanings of this word. In the most common, or “negative” sense, “having an argument” implies an emotional disagreement. This is not what is meant by how philosophers should argue. (Some of them have been known to slip-up, of course. As philosophers, however, they should know better.)
When the Asian financial crisis erupted in July 1997, an increase in regional financial market comovements followed. Even though the regional increases in covariances and correlations were the largest in East Asia during this period, similar increases occurred in Europe as well (Chakrabarti and Roll, 2002). Numerous studies have shown that financial crises tend to spread across country borders and financial markets often move more closely together during such episodes. However, each financial crisis is unique in its own way, and the recent financial crisis originating in the US subprime market is no exception. While there are a number of different explanations for the Asian financial crisis, most economists seem to agree that excessive lending practices in the US property market combined with a rapid expansion of complex financial products were among some of the main reasons behind the recent crisis.
These financial products typically bundled, among other things, mortgages together and made it more difficult to value them and resulted in banks relaxing their lending practices even more. The spread of the subprime crisis is also different from previous crises. Originating in the subprime sector, it soon spread through the US financial system and then onward to the European financial sectors, where financial institutions were exposed to the sudden and severe increase in defaults. Most Asian countries, on the other hand, have primarily been affected through real economy channels rather than via a spread among countries’ financial sectors. Not only developing countries such as China, Thailand and Vietnam but also advanced countries including Japan were affected by sudden shortfalls in their previously booming export sectors. However, even though the spread of the crisis has occurred through different channels, it has affected firm values in most countries around the world. This raises some important questions for policymakers and international investors alike: How closely are regional financial markets related? Is there a significant difference between market integration in Europe and Asia? If such a difference exists, is it similar to the differences seen during the Asian financial crisis, or are we witnessing a different evolution of dynamic regional market linkages?
