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(1) “It is not so much that people hate uncertainty but rather they hate losing”, (Amos Tversky, 1975).

Session 2018-2019

Autumn Term


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(1)   “It is not so much that people hate uncertainty but rather they hate losing”, (Amos Tversky, 1975).

Explain how loss aversion differs from risk aversion and describe how the portfolio investment trading behaviour of loss averse agents can result in discontinuous stock market movements.  

Suggested Readings

Kahneman, Daniel and Amos Tversky,1979, “Prospect Theory: An Analysis of Decision Under Risk”, Econometrica, vol. 47, No.2, p.268-291.

Rabin, Mathew and Richard Thaler, (2001) “Anomalies: Risk Aversion”, Journal of Economic Perspectives ,15, pp 219-232.

Gomes, Francisco J.( 2002), “Portfolio Choice and Trading Volume With Loss Averse Investors, Mimeo, London Business School, UK.

Berkelaar, Arjan and Roy Kouwenberg, (2000) , “Optimal Portfolio Choice Under Loss Aversion”, Econometric Institute Report, EI 2000-08/A, Erasmus University, Rotterdam.

 Slovic , P., and Michel-Kerjan, M., (Edited) (2010)  The irrational economist: Making decisions in a dangerous world, New York Public Affairs. 

(2)   “Market risk premium is one of the most important numbers in Finance.   Unfortunately, estimating and understanding its values has proven difficult ….  Empirical research has failed to document a significant positive relationship between expected returns and the level of market volatility”, (Scott Mayfield,2004).

Discuss the above in light of the mean variance framework of portfolio choice that greater expected return is required to compensate for higher variance of returns which proxies for market volatility.  Use evidence from regime switching models of stock returns to throw light on this. 

Suggested Readings:

Scott Mayfield, “Estimating the Market Risk Premium, 2004, Journal of Financial Economics, pp. 465-496.  

Ang, A. and A. Timmerman, 2011, “Regime Changes and Financial Markets”


Christie, A., 1982, “The Stochastic Behaviour of Common Stock Variances: Value, Leverage and Interest Rate Effects “,  Journal of Financial Economics, 10, 407- 432.

Mehra, R. and E.C Prescott, 1985, “ The Equity Premium: A Puzzle”, Journal of Monetary Economics, , 15, 145- 16

Rietz, T.A, 1988, “The Equity Risk Premium: A Solution”,  Journal of Monetary Economics, 22, 117-131.

Scruggs, J.T, “Resolving the Puzzling Intertemporal Relation Between the Market Risk Premium and Conditional Market Variance: A Two- Factor Approach”, The Journal of Finance, vol. LIII, no. 2.

Pástor, L. and R.F, Stambaugh, 2001, “The Equity Premium and Structural  Breaks”, Journal of Finance, Vol. LVI, No. 4.

French, K., G.W. Schwert, R.F. Stambaugh, 1987, ‘Expected Stock Returns and Volatility’, Journal of Financial Economics,  3-29. 

Cotter, J. and E. Salvador,    The non-linear trade-off between return and risk:

a regime-switching multi-factor framework


(3)   “Synthetic securitization marks the pinnacle of financial engineering that brought the financial system to its knees.”  Discuss how poor financial product design and perverse incentives from Basel II worked to destroy the financial system.

Suggested Readings:

Acharya, V. & Richardson, M. (2010) “Causes of the Financial Crisis’, Critical Review, 21:2, 195 – 210.

Alessandri,P. & Haldane A.(2009)  “Banking on the state”, Paper based on presentation at the Federal Reserve Bank of Chicago, 12 International Banking Conference.

Blundell-Wignall A. & Atkinson P.(2008), “The Subprime Crisis: Causal Distortions and Regulatory Reform”, in: Paul Bloxham and Christopher Kent, Lessons from the Financial Turmoil of 2007 and 2008, Proceedings of a Conference held at the H.C. Coombs Centre for Financial Studies, Kirribilli, on 14-15 July 2008; Reserve Bank of Australia.

Behn   M. ; Rainer Haselmann , Vikrant Vig (2014),

“The Limits of Model-Based Regulation”


Brunnermeier, M., A. Crockett, C. Goodhart, A. Persaud & H. Shin, (2009), “The fundamental principles of financial regulation”, Geneva Reports on the World Economy 11, International Center for Money and Banking Studies.

Hamerle, A. , Liebig, T., & Schropp, H-J, 2009, “Systematic risk of CDOs and CDO arbitrage”,  Deutsche Bundesbank Discussion Paper Series 2: Banking and Financial Studies No 13/2009.

Hull J., M. Predescu & A. White (2004) “The relationship between credit default swap spreads,bond yields, and credit rating announcements”, Journal of Banking and Finance , vol. 28, no. 11, pp. 2789-2811.

Hu, J.  (2007) “Assessing the Credit Risk of CDOs Backed by Subprime Securities: Ratings Analysts’ Challenges and Solutions”, Mimeo Senior VP of Moodys

Markose, S., B. Oluwasegun, and S. Giansante (2012)  August ,  "Agent Based Financial Network (MAFN) Model of US Collateralized Debt Obligations (CDO): Regulatory Capital Arbitrage, Negative CDS Carry Trade and Systemic Risk Analysis",  Chapter in Book :Simulation in Computational Finance and Economics: Tools and Emerging Applications, Editor(s):  Alexandrova-Kabadjova B., S. Martinez-Jaramillo, A. L. Garcia-Almanza, E. Tsang,  Publisher: IGI Global.

Markose , Sheri  Multi-agent Financial Network Models and Systemic Risk Management: A New Complexity Perspective

(4)   “The stock market crash of 1987 which resulted in a 22% loss of value was preceding by the equity futures trading at a 30% to the spot market. The flash crash of 2010 also started with large selling on the SP-500 futures market and a misalignment between spot and futures prices which led to large price falls on spot market.”  Stephen Figlewski had noted that such futures spot misalignments are difficult to correct by arbitrage.  In both cases high frequency program trading was blamed.  Discuss the role and limits of arbitrage in financial markets, in particular why arbitrageurs need access to cheap leverage, Mitchell and Pulvino (2012).  Using models of portfolio insurance, short selling and stock index futures hedging and arbitrage strategies, discuss their implications for stock market crashes.  Also relate this to how the large forward selling in S&P 500 futures market was given as an explanation of the 2010 May 6 Flash Crash on the S&P 500.          

Suggested Readings

Brady, N., (1988) Report of the Presidential Task Force on Market Mechanisms, Government Printing Office, Washington DC.

John Merrick,1988, “Hedging with Mispriced Futures”, Journal of Financial and Quantitative Analysis,  Vol  23 No. 4, December.

Rubinstein, Mark, 1998, “Comments on the 1987 Stock Market Crash: Eleven Years Later”, Risk in Accumulation Products, Society of Actuaries, 2000.

Stephen Figlewski, 1985,“Hedging With Stock Index Futures: Theory and Application in a New Market”, Journal of Futures Markets, 5, pp. 183-99.

Kolb, R., 1997, Futures, Options and Swaps, Blackwell Publishers Inc., Chapters 7-8.

J. Danielsson, and Hyun Song Shin, 2002, “Endogenous Risk”, Financial market Group Mimeo, LSE.  (This paper contains a good account of portfolio insurance.)


Mitchell, M. and T. Pulvino (2012) “ Arbitrage Crashes and Speed of Capital”

Journal of Financial Economics, 2012, vol. 104, issue 3, pages 469-490


Miyazaki, Hirokazu (2007)Between arbitrage and speculation: An economy of belief and doubt”. Economy and Society 36: 397416Search Google Scholar

Explanation that the Flash Crash of the S&P 500 started in the E-mini S&P 500 futures market


(5)   “The recent expansion of derivative markets constitutes a major step in the quest for the “Holy Grail” of achieving a complete securities market structure” (Danthine and Donaldson) and the belief that this helps in optimal risk sharing.

In the context of the recent financial crisis in which credit derivatives, in particular, were implicated, discuss how the derivatives markets valued at $700 trillion in terms of gross notional became too interconnected to fail. Explain how financialization of commodities derivatives has contributed to increasing the price volatility of the underlying in these markets rather than stabilizing them.

Suggested Readings

Brock, W. A., Hommes, C. H. & Wagner, F. O. O., 2008, “ More hedging instruments may destabilise markets”. Journal of Economic Dynamics and Control. 33, 1912–1928 (2008)

Rajan, G.R., 2006, “Has Finance Made the World Riskier?” European Financial Management 12(4), 499–533.

Caccioli, F., Marsili, M. & Vivo, P. Eroding market stability by proliferation of financial instruments. Eur. Phys. J. B 71, 467–479 (2009)

Darby, M., “Over the Counter Derivatives and Systemic Risk to the Global Financial System, NBER Working Paper No. 4801.

Kiff, J. Elliot, J. , Kazarian, E., Scarlatta, J., Spackman, C. , 2009, “Credit Derivatives: Systemic Risks and Policy Options”, IMF Working Paper 09/254.

 Duffie, D. , Li, A., Lubke, T. (2000)“Policy Perspectives on OTC Derivatives Market Infrastructure” Milton Friedman Institute Working Paper Series No. 2010-002.

Andrew Haldane; Rethinking the Financial System http://www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf

Markose, S., S. Giansante, and A. Shaghaghi, (2012), “Too Interconnected To Fail Financial Network of U.S. CDS Market:Topological Fragility and Systemic Risk”,  Journal of Economic Behavior and Organization, May 21, 2012 Available online at:http://dx.doi.org/10.1016/j.jebo.2012.05.016  (Top 20 most down loaded paper)

Markose , S. Systemic Risk from Global Financial Derivatives: A Network Analysis of Contagion and Its Mitigation with Super-Spreader Tax  , IMF Report

Suleyman, B. and A. Pavlova (2015) “AModel of Financialization of Commodities”,


Use Sections 5 and 6 on Financialization of Commodities Markets


Box 3 on page 29 gives excerpts from the US November 20, 2014, the 403-page report titled Wall Street Bank Involvement with Physical Commodities

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