Asian Review of Financial Research

pISSN: 1229-0351
eISSN: 2713-6531

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Asian Review of Financial Research / February 2010 Vol. 23 No. 1

The Efficiency of Intraday Price Discovery in the Seoul Won/Dollar FX Market

Junghoon Seon;Kyong Shik Eom

Asian Review of Financial Research :: Vol.23 No.1 pp.1-26

Abstract
The Efficiency of Intraday Price Discovery in the Seoul Won/Dollar FX Market ×

This paper examines the efficiency of intraday price discovery in the Seoul won/dollar FX market. More specifically, we investigate three aspects of the efficiency of price discovery: the speed of price discovery, the degree of price discovery per trade, and the accuracy of price discovery in the market. The speed and degree of intraday price discovery are measured by WPC (weighted price contribution) and WPCT (WPC per trade), which are devised by Barclay and Warner (1993) and Barclay and Hendershott (2003), respectively. The accuracy of intraday price discovery is measured by VR (variance ratio) proposed by Lo and MacKinlay (1988). We use the real- time transaction data and two-minute-interval quotes data of inter-dealer trades, brokered through Seoul Money Brokerage Services Ltd. from April 1 to May 30, 2003. Price discovery is defined as the dynamic process by which prices incorporate new information in financial markets including FX market. Since price discovery is generally the most important function in financial markets, its efficiency has become a very valuable public good. Despite the importance of its economic implications, the studies on the efficiency of intraday price discovery on FX market are very limited. Previous studies can be generally classified into two categories: those that belong to the first category indirectly analyze the efficiency of intraday price discovery by comparing it with that of other FX markets, while those of the second category directly analyze an aspect of the efficiency of intraday price discovery on an FX market. Rosenberg and Traub (2006) and D'Souza (2007) fall into the first category. Rosenberg and Traub (2006) examines the relative information shares of spot and futures FX markets using the methodology of Hasbrouck (1995) for two sample periods: May-August 1996 and March-May 2006. D'Souza (2007) investigates information content of order flows in inter-dealer brokered markets during two years from October 2000 to September 2002 using real-time transaction data. He reports that trades are more informative when they are initiated in a local country rather than in major foreign exchange centers like London and New York. Kaul and Sapp (2009) is the only existing study that falls into the second category. The study analyzes the accuracy of inter-dealer Euro-USD and CAD-USD FX markets for the year of 2000 through the VR test and GARCH analysis, and reports that the relative accuracy of price discovery is the greatest when trading activity is high and dealer concentration reaches its peak. The distinct features of our paper from the previous domestic and international studies on the efficiency of intraday price discovery are summarized as follows. First, this is domestically the first paper to directly examine the efficiency of intraday price discovery. Our paper provides another angle for the second category in the field, which currently includes the only paper by Kaul and Sapp (2009). Second, as far as we know, this is domestically and internationally the first paper to study all the dimensions of the efficiency of price discovery. Kaul and Sapp (2009), the only existing study of the second category, on the other hand, has a limitation of examining only accuracy out of three dimensions of efficiency of price discovery. Third, this paper provides an answer to the following question: “To what degree is the efficiency of intraday price discovery in the Seoul FX market attained during a trading day?” The answer is yet to be provided by the existing domestic literature. Eom et al. (2008) finds that the autocorrelation of daily won-dollar exchange rates disappeared after January 2001. This result indicates that the efficiency of price discovery has been achieved in the market at least in the frequency of daily since then. There has not been any further study which investigates the degree of intraday efficiency of price discovery is attained. The overall results of this study can be summarized as follows. First, the intraday pattern of price discovery exhibits an inverse J-shape. In addition, most of intraday price discovery is attained during the first 90 minutes just after the market opening. To be more specific, during the close-to-close (open-to-close) time span, about 75.3% (44.5%) of price discovery occurs during the first 90 minutes just after the market opening. After that, the speed and degree of price discovery decrease up to the last 60 minutes before the market closing, from which they increase again. Second, the efficiency of intraday exchange rates, after the market opening, is attained up to lunch break. During the period from the market opening to lunch break, there exists the autocorrelation in won/dollar exchange rates. When the short horizon is expanded from 30 minute to 120 minute with the long horizon fixed at a trading day, the computed VRs are significantly greater than 1. This result indicates that won/dollar exchange rates under-react to information in the short horizon, and thus there exists a positive autocorrelation in exchange rate returns. Meanwhile, if the short horizon is expanded to 150 minute i.e. the entire morning session, then the computed VR is not significantly greater than 1, indicating that positive autocorrelation does not exist. Overall, our findings imply that the efficiency of price discovery in the Seoul won/dollar FX market is very high; the process of price discovery occurs very quickly with great accuracy.

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A New Approach for Pricing Deposit Insurance

Keehwan Park;Saekwon Kim

Asian Review of Financial Research :: Vol.23 No.1 pp.27-54

Abstract
A New Approach for Pricing Deposit Insurance ×

A financial crisis is often triggered by negative external factors in the credit market. In case of the recent global financial crisis, the trigger was the sudden collapse of Lehman Brothers. Hence, it can be a reasonable notion to reflect the cost of externality on a fair deposit insurance premium in order to absorb consequential market distortion. This is akin to correcting the market distortion by taxing air pollution. Pedersen and Roubini (2008) is the first paper to address this issue by proposing the idea as a viable way to restore financial stability. In this paper, we reframe Merton's (1974) credit risk model based on a general equilibrium context and price the systematic risk for deposit insurance which is considered to be the cost of the negative externality. For that purpose, we make use of the general equilibrium models such as Cox, Ingersoll and Ross (1985), Ahn and Thompson (1988) and Bates (1991). The model assumes that the return dynamics on the firm value process follows a geometric Brownian motion. This kind of stochastic dynamics is made possible by an economy's random technological change over time. Park, Ahn and Kim (2009) has derived the risk-neutral dynamics for the firm value process using the Ahn and Thompson's model (1988). The risk-neutral dynamics allows us to price a risky debt in a general equilibrium setting. Applying Ito's lemma to the equilibrium relationship between the firm (asset) value and its debt value, we derive an equilibrium return dynamics on the debt. From this equilibrium return dynamics, we obtain an equilibrium relationship between the asset risk premium and the debt risk premium for a firm. Particularly, we show that the systematic risk premium depends upon the following variables: 1) the relative riskiness of debt (deposit) to asset, 2) asset beta, and 3) the investor's relative risk aversion. The relative riskiness of debt to asset is largely associated with the bank's financial risk represented by the leverage (debt to asset) ratio. The asset beta is determined by the asset return covariance with the economy's total wealth. According to Merton (1977), the fair deposit insurance premium per dollar is defined as a present value of the expected default loss (per dollar deposited) under Martingale (Q) measure. Deposit insurance premium is, henceforth, computed as a sum of the present value of the expected loss to depositors from their bank default and its systematic risk premium; the risk-neutral default probability under Q measure accounts for the risk premium beyond its expected default loss. The expected default loss is, in turn, estimated using the classical logit model. In order to estimate the debt premium, we impute the firm asset return (unobservable) from its stock return (observable) by employing the iterative procedure used by Vassalou and Xing (2004). This procedure is similar to the KMV's procedure outlined in Crosbie (1999). The procedure is based on the Merton's notion (1974) that a firm's stock is, as a matter of fact, a call option on the firm's asset with the book value of the firm's liability being the strike price. We first estimate the stock return volatility from the daily stock prices and use it as an initial value for the asset return volatility. Using the Merton's relationship, we compute daily asset values for each trading days. We then compute the asset return volatility for the next iteration. The procedure is repeated until it converges. A striking difference of our model from the traditional option based model such as Merton (1977) and Marcus and Shaked (1984) is that our model allows us to estimate the expected default loss and the systematic risk premium explicitly and separately. Our model also differs markedly from that of Cooper and Davydenko (2004),which derives a relationship between the equity risk premium and the debt risk premium, in that ours is, in nature, a general equilibrium model while theirs is not. An empirical analysis is done for the Korean commercial banks and the mutual savings banks and is compared to the results obtained by the prior studies such as Marcus and Shaked (1984), and Duffie, Jarrow, Purnanandam and Yang (2003). Our model generally produces a higher premium than what one would obtain from the Marcus and Shaked's (1984), which tends to underestimate it. We, furthermore, find that the expected default losses are higher for the mutual savings banks than the commercial banks, but the systematic risk premia are the opposite. We think that the commercial banks tend to be more procyclical as evidenced by their higher beta coefficients. The systematic risk premia varied over the business cycle, and reached the peak in the year of 2008. They are negatively related to the degree of financial stability. We recommend that the deposit insurance premia should be charged at the rates reflecting the differences in the systematic risk premia.

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Does Dollar-Cost-Averaging Strategy Really Outperform Lump-Sum Strategy in the Fund Investment?

Young K. Park;Sang Youp Lee

Asian Review of Financial Research :: Vol.23 No.1 pp.55-88

Abstract
Does Dollar-Cost-Averaging Strategy Really Outperform Lump-Sum Strategy in the Fund Investment? ×

The Korean fund market has experienced a tremendous growth in the past several years. Especially, the growth in the equity type fund has been phenomenal; for instance, its balance grew from 6.5 trillion won in March 2005 to 127.7 trillion won as of November 2008. While low interest rate and steady growth trend in the world stock market have driven the increase in the market size, the introduction of systematic monthly fund investment method, which is virtually the dollar cost averaging investment, has also played a significant role. In fact, since its introduction, fund distributors often advise individual investors in favor of the dollar cost averaging method, asserting that it generates higher returns with lower risks compared to the lump sum investment strategy; accordingly, many individual investors have participated in equity-type fund investment. This study aims to compare the performance of the lump sum (LS) investment strategy and dollar cost averaging (DCA) investment strategy in the Korean mutual fund market to check whether the DCA method really outperforms the LS method. Thus far numerous debates have followed over which of these two investment strategies is better since Constantinides (1979) which suggests that the LS investment strategy outperforms the DCA investment strategy. Prior to his paper, it was generally accepted that DCA is better than LS due to the dollar cost averaging effect. However, many theoretical and empirical researches since Constantinides (1979) have suggested that LS actually outperforms DCA. Most of the literature on this issue, regretfully, has been solely based on theoretical analysis or simulation methods only. Even empirical analysis has relied on hypothetical accounts rather than actual investment accounts. In this regard, this paper is different from the past literature in that we used not only the conventional simulation methodologies, but also individual investors' actual account data to effectively compare the performance of LS and DCA investment strategies. The data for this paper are comprised of: i) KOSPI stock index and bond yields from January 1988 to December 2008 for the historic simulation; ii) KOSPI stock index and bond yield from January 2001 to December 2008 for Monte Carlo simulation; and iii) 36,890 individual accounts (of which 22,449 using DCA strategy and 14,441 using LS strategy) from December 2004 to November 2008 for the real investor data analysis. Our major findings are as follow. First, the historic simulation shows that LS investment strategy provides better return for short-term investment horizon (1 year) while DCA investment strategy outperforms for the long-term investment horizon (3 year and 5 year). This result holds robust whether we use simple return, Sharp measure, or Jensen's alpha to measure the fund account performance. The Monte Carlo simulation shows similar results: the LS investment strategy gives better return for the 1 year investment horizon. For the 2 year investment horizon both strategies are comparable while DCA starts to outperform LS when the investment horizon is longer than 3 years. Second, we use individual fund investment account data to compare DCA and LS strategies and find that DCA outperforms LS during our study period which is divided into bullish period and bearish period. We find that the marginal effect of DCA on the risk adjusted return (Jensen's alpha) is positive even after controlling for the market conditions. It is also found that DCA becomes a better investment strategy than LS when the investment term is longer and the investment capital is larger. Third, we compared two different methods to close down DCA investment account. Fund investors with DCA account can either choose automatic sell-off when their monthly saving contract matures or wait to select the better time to sell-off his or her fund even after the contract term expires. We find that investors who choose different sell-off time other than automatic contract expiration time do not perform better, and this indicates that investors as a group do not have ability to choose better investment exit time. Finally, we conduct the sensitivity analysis for the fund investment in response to the changes in the stock prices. We find that both fund purchase and fund sell-off are sensitive to stock price movements. Both purchase and sales of fund increase when the stock price (KOSPI index) rises, and they decrease when the stock price falls. Between the purchase and sales, fund purchase activity is more sensitive to the stock price movements than fund sales activity is while LS investors are more sensitive than DCA investors are. Our study result suggests that individual equity type fund investors are better off when they invest with DCA strategy and for a longer time horizon. This paper makes a meaningful contribution to the fund and investment literature as it is the first paper to examine the actual investors' account to compare the DCA and LS fund investment methods. Nonetheless, we acknowledge that some part of the result may be sensitive to the study period.

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