Int. J. Financial Stud., Volume 6, Issue 2 (June 2018) – 26 articles

Financial inclusion has become a subject of growing interest for academics, professionals, and policy-makers in recent times. Researchers stress the importance of financial inclusion and highlight the significant role of financial institutions, such as banks, in promoting financial inclusion. Therefore, it is imperative to analyse the role and commitment of banks in promoting financial inclusion, especially those financial institutions (i.e., Islamic banks) which came into existence to promote socio-economic justice through redistribution of wealth in society. The study is built on the argument that Islamic banking business model is based on intangible sources i.e., Shari’ah law and such sources are exploited to create value i.e., stability, profitability and financial inclusion. The empirical analysis support the hypothesis that Islamic banks utilize various tangible and non-tangible resources to promote financial inclusion. Hence, Islamic banks are serving as the ultimate source of financial inclusion in the society. Full article

The purpose of this paper is to examine the role of external auditors in potentially approving or limiting a firm’s earnings management practices in institutional settings which do not provide incentives for auditors to deliver high audit quality. We use signed discretionary and performance-adjusted discretionary accruals as proxies for earnings management, and audit firm size (Big 4 vs. Non-Big 4) and audit opinion type (Qualified vs. Unqualified) as measures for audit quality. Using a sample of 183 firms listed on the Karachi Stock Exchange, Pakistan for the five-year period from 2009 to 2013, we find that there is statistically no significant difference between earnings management activities of firms audited by Big 4 and non-Big 4 auditors. Audit opinion is not being issued in response to the earnings management activities being employed by firms. Further consistent with the entrenchment hypothesis, we find that earnings management is pervasive in family controlled firms and Big 4 auditors do not moderate the relation between family firm dominance and earnings management. A small audit market coupled with non-existent litigation risk, strong economic bonding of auditors with their clients, lower investor protection, poor enforcement mechanisms and dominance of firms by influential family groups lead auditors to behave opportunistically, which undermines their independence and objectivity. Full article

The study primarily explores the linkage between wealth effects, arising from stock and housing market channels, and household final consumption for 11 advanced countries over the period from 1970 Q1 to 2015 Q4. As a modelling strategy, we employ regression analysis through the common correlated effects mean group (CCEMG) estimator, as well as Durbin–Hausman cointegration and Dumitrescu and Hurlin (2012) causality tests. The study provides various pieces of evidence through whole-panel and country-level analyses. In this respect, we find that consumption is mostly explained by income and housing wealth is positively and significantly correlated with consumption. As counter-intuitive evidence, we detect a negative linkage between consumption and stock wealth. The evidence also suggests a long-run cointegration relationship among consumption, income, interest rates, housing wealth, and stock wealth. Moreover, we find bidirectional causality between consumption and income, stock wealth, housing wealth, and interest rates. Overall, the evidence implies that housing wealth, rather than stock wealth, is the primary source of consumption growth in advanced countries. Full article

The aim of this article is to analyze the concept of “vulnerability” to natural disasters, focusing on the specific case of the Italian earthquake insurance. In this sense, we examine in detail the vulnerability definition and its relevance for citizens and for insurance companies. Then we investigate the Italian insurance market characterized by a very low penetration of natural disasters insurance and the potential effects of a recent Government initiative called “Sisma Bonus”. The idea is that its technical content, in terms of a specific definition of vulnerability, may contribute to developing a better consciousness about vulnerability and a larger diffusion of insurance products. Full article

Foreign direct investment (FDI) inflows have increased considerably in the globalized world as of the mid-1980s. The main objective of this research is to analyze interactions between FDI inflows and financial sector development in Central and Eastern European Union countries between 1996 and 2015 with panel data analysis. Our findings reveal that there is no cointegrating relationship among FDI inflows, investments of foreign portfolio, and the development of financial sectors, but there is a one-way causality from development of financial sectors to FDI inflows over the short run. Full article

This paper proposes a Markov regime-switching asset-pricing model and investigates the asymmetric risk-return relationship under different regimes for the Chinese stock market. It was found that the Chinese stock market has two significant regimes: a persistent bear market and a bull market. In regime 1, the risk premiums on common risk factors were relatively higher and consistent with the hypothesis that investors require more compensation for taking the same amount of risks in a bear regime when there is a higher risk-aversion level. Moreover, return dispersions among the Fama–French 25 portfolios were captured by the beta patterns from our proposed Markov regime-switching Fama–French three-factor model, implying that a positive risk-return relationship holds in regime 1. On the contrary, in regime 2, when lower risk premiums could be observed, portfolios with a big size or low book-to-market ratio undertook higher risk loadings, implying that the stocks that used to be known as “good” stocks were much riskier in a bull market. Thus, a risk-return relationship followed other patterns in this period. Full article

The aim of this study was to analyze the impact of bank-specific, industry-specific and macroeconomic variables on the profitability of banks in Pakistan. This study applied the two-step generalized method of momentum (GMM) system estimator on an unbalanced dynamic panel of 28 banks over the latest period 2007–2016. The robust results reveal that the bank’s profitability in Pakistan is explained by size, higher solvency, financial structure, operating cost, labor productivity, market power, and economic growth. We also found an inverted U-shape relationship between banks size and profitability. Herfindahl–Hirschman Index (HHI) was applied to evaluate the impact of market power and found results in support of Structure Conduct Hypothesis. On the other hand, credit quality, operational efficiency, banking sector development, inflation, and industry concentration are found to be negatively and significantly related to the profitability of banks. Further, this study found lower profitability of banks during the government transition. The Mean comparison of profitability indicates that specialized banks (SB) in Pakistan are generating higher net interest margin (NIM) than all commercial banks (ACB). However, the empirical results of this study are robust and consistent with previous literature. Full article

In the field of portfolio management, practitioners are focusing increasingly on risk-based portfolios rather than on mean-variance portfolios. Risk-based portfolios are constructed based solely on covariance matrices, and include methods such as minimum variance (MV), risk parity (RP), and maximum diversification (MD). It is well known that the performance of a mean-variance portfolio depends on the accuracy of the estimations of the inputs. However, no studies have examined the relationship between the performance of risk-based portfolios and the estimated accuracy of covariance matrices. In this research, we compare the performance of risk-based portfolios for several estimation methods of covariance matrices in the Japanese stock market. In addition, we propose a highly accurate estimation method called cDCC-NLS, which incorporates nonlinear shrinkage into the cDCC-GARCH model. The results confirm that (1) the cDCC-NLS method shows the best estimation accuracy, (2) the RP and MD do not depend on the estimation accuracy of the covariance matrix, and (3) the MV does depend on the estimation accuracy of the covariance matrix. Full article

An examination of Brexit and its initial impact on the main stock markets in the Greater China Region (GCR) was conducted using augmented market models that integrate Economic Policy Uncertainty (EPU) and implied volatility (VIX). The results do not seem to align with research in the field that has suggested that the EPU index helps to identify if market participants are reacting to political events. The main research findings suggest that Brexit does not appear to have an impact on the performance of market returns in the region and the influence of economic policy uncertainty in the GCR appears to be insignificant, except for Hong Kong. Overall, China’s stock markets do not seem to be panicking and overreacting to unfolding events in the UK, and market instability in the region appears to be more associated with global and regional events that are better captured by the VIX index. Full article

This paper investigates the determinants of credit risk from a broad perspective. Particular attention is given to the role of housing affordability and household indebtedness. However, the impact of credit market developments and regulations is also closely examined. Using a large panel of countries it is found that housing affordability and household fragility significantly affect the risk of banks’ loan portfolios. In addition, an analysis of the conditional quantiles of non-performing loan ratios reveals that financial institutions in countries with greater levels of financial liberalization and less regulated markets also experience greater credit risk. Full article

We analyze a novel alpha momentum strategy that invests in stocks based on three-factor alphas which we estimate using daily returns. The empirical analysis for the U.S. and for Europe shows that (i) past alpha has power in predicting the cross-section of stock returns; (ii) alpha momentum exhibits less dynamic factor exposures than price momentum and (iii) alpha momentum dominates price momentum only in the U.S. Connecting both strategies to behavioral explanations, alpha momentum is more related to an underreaction to firm-specific news while price momentum is primarily driven by price overshooting due to momentum trading. Full article

In the wake of the 2008 financial crisis, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) created a list of systemically important financial institutions (SIFIs) with the intention of determining which financial institutions were important enough to the global market that their failure would result in systemic collapse. In this work, we create a model that modifies the BCBS’s five indicators of size, interconnectedness, cross-jurisdictional activities, complexity, and substitutability and apply these measures of systemic stress to governments. Although the cross-jurisdictional activities and size were almost identical to the SIFI calculations, the others had to be adapted to mirror the intent of the BCBS. Interconnectedness is calculated by simulation of what would happen to nearby countries if a country defaulted. Substitutability is estimated by the number of services that would no longer be provided if the government ceased to exist. Complexity is market-based and is derived from credit default swap (CDS) spreads. The original application of the model was to track the systemic interdependence of the Eurozone, with particular emphasis on the case of Greece. We anticipate that this model can be used in regional fiscal situations beyond the Eurozone. Full article

Correlation network based on similarity is the common approach in financial network analyses where the Minimal Spanning Tree (MST) is used to filter the important information contained in the network. In this paper, by considering a distance matrix based on dissimilarities among multivariate time series of currency, a topological network was analyzed. A topological network can explain to what extent two or more multi-dimensional currency structures are different from each other. For this purpose, we examined the topological network of currency market from 2005 to 2011 in terms of the subprime crisis. After that, the multivariate time series evolution of MSTs were analyzed in terms of the structural changes for three periods (before, during, and after the crisis). Moreover, since the clusters of currencies in network analysis are due to regional factors, by considering each region, which is composed of a number of currencies, as an element on the financial system, we attempted to determine how a region interacts with the other regions in crisis periods. This motivated us to introduce a region-based network analysis of currencies. Since each region consisted of a different number of currencies compared to the others, the appropriate network analysis was in multivariate setting. Finally, the applications of the method were presented with the situation of a currencies crisis behavior. The results indicate significant changes in the topological structures of MSTs when their properties are compared to each other. Full article

This contribution takes a new look at the gravity equation model in relation to foreign direct investment (FDI) of leading industrialized countries which presents a useful basis for assessing certain potential impacts arising from BREXIT—the envisaged leaving of the EU by the United Kingdom. The gravity equation estimated subsequently allows one to consider the case of BREXIT and the broader role of EU membership and other variables. Looking at the period from 1985 to 2012 for a dataset which contains 34 OECD (Organisation for Economic Co-operation and Development) countries, Pseudo Poisson Maximum Likelihood (PPML) dyadic fixed estimations take into account a broad set of approaches and variables. Besides the traditional variables of the EU/EU single-market membership of the source country and of the host country, we further consider the role of trade openness as well as corporate tax rates and the ratio of inward FDI stock to total capital stock. The analysis shows that trade openness is a variable which can be largely replaced by the inward FDI stock/capital stock ratio so that gravity FDI modeling with a strong emphasis on trade openness is likely to overstate the role of trade and to understate the role of relative FDI accumulation effects. The implication for BREXIT analysis is that the UK will face three impulses for FDI inflows: (1) leaving the EU single market will strongly reduce FDI inflows; (2) if foreign ownership in UK capital stock should strongly increase in the run-up to the BREXIT year 2019, part of the dampening effects of leaving the EU will be mitigated by the increase of the FDI stock/capital stock ratio, which in turn is likely to reflect a Froot–Stein effect related to real pound depreciation for 2016–2018; (3) to the extent that the UK government will want to reinforce output growth through higher FDI inflows, a reduction of corporate taxation could generate high effects but could also stimulate a downward international corporate tax reduction game. Full article

The purpose of this study is to analyze the impact of the growth of the Brazilian winter corn crop on the dynamics between domestic Brazilian prices and international prices as well as spot and futures prices in Brazil. Econometric time-series methods tests were applied using Brazilian spot and futures prices and U.S. futures prices. The statistical analysis found evidence that a long-run relationship between Brazilian and U.S. prices had developed, and the Brazilian futures market developed a more dominant role in the relationship between spot and futures prices domestically. These findings were particularly noticeable after 2002, when expanding corn production in Brazil was leading to greater participation in the international market (exports) and increasing trading in the Brazilian futures market. Full article

This article investigates the effectiveness of TAIEX (Taiwan Stock Exchange) futures, Taiwan 50 futures, and nonfinance nonelectronics subindex (NFNE) futures for cross hedging the price risk of stock sector indices traded on the Taiwan stock exchange. A state-dependent volatility spillover GARCH hedging strategy is developed to capture the regime switching global equity volatility spillover effect. Empirical results show that the NFNE futures exhibit superior effectiveness as an instrument for hedging stock sector exposures compared with the TAIEX and Taiwan 50 futures. Simultaneous hedge using both NFNE and MSCI (Morgan Stanley Capital International) world index futures further improves the hedging effectiveness compared with the hedging strategy using only the NFNE futures. This shows the importance of hedging the global equity systematic risk of stock sectors by considering the comovement between domestic and global equity markets. Full article

The goal of this study was to examine the predictability and persistence of earnings of the European football clubs and whether the new Union of European Football Associations (UEFA) Financial Fair Play (FFP) licensing regulation has forced clubs to produce a more predictable earnings stream. We utilized a sample of 109 European top-tier clubs over the period 2008–2016, summing up to 844 firm-year observations. Empirical evidence indicated that the cash flow component of earnings is more relevant in predicting one-year ahead earnings than accruals. This positive impact of cash flows for predicting earnings is more significant after the FFP regulation since earnings predictability has increased during that period. Moreover, the abovementioned finding is more significant for the smaller league clubs rather than the Big-5 league clubs. This finding is attributed to the fact that smaller league clubs are more in need of UEFA prize money relative to Big-5 league clubs, thus they are more incentivized to produce a more predictable earnings stream. Full article

The Halloween effect is one of the most famous calendar anomalies. It is based on the observation that stock returns tend to perform much better over the winter half of the year (November–April) than over the summer half of the year (May–October). The vast majority of studies that investigated the Halloween effect over the recent decades focused only on stock indices. This means that they evaluated whether a stock index follows the Halloween effect pattern, but they omitted digging a little deeper and analyze the Halloween effect on the individual stocks level. This paper investigates to what extent the blue-chips stocks included in the Dow Jones Industrial Average are affected by the Halloween effect and whether the Halloween effect is widespread or the behavior of the whole index is driven by only a handful of stocks that are strongly affected by the Halloween effect. The results show that, although the strength of the Halloween effect varies quite rapidly from stock to stock, the vast majority of analyzed stocks experienced a notably higher average winter period than summer period returns over the 1980–2017 period. Moreover, in 18 out of 35 cases, the Halloween effect was statistically significant. Full article

This paper analyzes the evolution of the main theories regarding the capital structure and the related impact on risk and corporate performance. The capital structure is a dynamic process that changes over time, depending on the variables that influence the overall evolution of the economy, a particular sector, or a company. It may also change depending on the company’s forecasts of its expected profitability, capital structure being, in fact, a risk–return compromise. This study contributes to the literature by investigating the drivers of capital structure of the firms from the Romanian market. For the econometric analysis, we applied multivariate fixed-effects regressions, as well as dynamic panel-data estimations (two-step system generalized method of moments, GMM) on a panel comprising the companies listed on the Bucharest Stock Exchange. The analyzed period, 2000–2016, covers a cycle with significant changes in the Romanian economy. Our results showed that leverage is positively correlated with the size of the company and the share price volatility. On the other hand, the debt structure has a different impact on corporate performance, whether this calculated on accounting measures or seen as market share price evolution. Full article

This paper is a contribution to the ongoing debate on the benefits and drawbacks of bank revenue diversification. Revenue diversification may benefit banks if diversified activities are inherently less risky and possess high returns, while it may hurt banks if diversified activities are more risky and have low returns. Analyzing a panel dataset of 200 commercial banks from all South Asian countries, we found that overall revenue diversification into non-interest income has a positive impact on the profitability and stability of South Asian commercial banks. We further observed that different types of non-interest income-generating activities have different impacts on bank performance and stability. While fees and commission incomes have a negative impact on the profitability and stability of South Asian commercial banks, other non-interest income has a positive impact. Our results imply that banks can benefit from revenue diversification if they diversify into specific types of non-interest income-generating activities. Our findings are robust and relevant to the use of alternative measures of revenue diversification, profitability and stability. Full article

We propose a simple but practical methodology for the quantification of correlation risk in the context of credit derivatives pricing and credit valuation adjustment (CVA), where the correlation between rates and credit is often uncertain or unmodelled. We take the rates model to be Hull–White (normal) and the credit model to be Black–Karasinski (lognormal). We summarise recent work furnishing highly accurate analytic pricing formulae for credit default swaps (CDS) including with defaultable Libor flows, extending this to the situation where they are capped and/or floored. We also consider the pricing of contingent CDS with an interest rate swap underlying. We derive therefrom explicit expressions showing how the dependence of model prices on the uncertain parameter(s) can be captured in analytic formulae that are readily amenable to computation without recourse to Monte Carlo or lattice-based computation. In so doing, we crucially take into account the impact on model calibration of the uncertain (or unmodelled) parameters. Full article

The description of the dynamics and fluctuations of macro variables remains one of the most exciting problems of financial economics. This paper models macro variables via the description of transactions between agents. We use risk ratings x of agents as their coordinates in the economic space. Transactions like buy–sell, investment, credits, etc., between agents change their extensive financial and economic variables. Aggregates of transactions between all agents with risk ratings x and y define the macro transactions between points x and y. Macro transactions determine the evolution of macro variables. Interactions between different transactions outline their dynamics and fluctuations. We model macro transactions and the interactions between them by economic hydrodynamic-like equations in the economic space. As an example, for simple model interactions between credit–loans and loans–repayment transactions we derive economic hydrodynamic-like equations and wave equations for near perturbations of macro transactions and study simple wave solutions and their consequences. Waves of macro transactions in the economic space propagate from high to low risk agents or vice versa and define the fluctuations of macro financial variables. The existence and diversity of waves and fluctuations of macro transactions in simple models clarifies the importance of wave processes for macro financial modeling and forecasting. Full article

The purpose of this study is to examine the efficiency of the banks in Lithuania by employing the DEA method and evaluate bank performance in a low interest rate environment. The efficiency scores were calculated with a non-parametric frontier input-oriented DEA technique with the variable returns to scale (VRS) and the constant returns to scale (CRS) assumptions. Five alternative models with different input-output combinations were developed, based on production, profitability and intermediation dimensions. The main bank profitability measure—the return on assets (ROA) ratio—was employed to validate the results obtained using the DEA method. The Lithuanian bank’s efficiency analysis based on the VRS assumption shows that better results are demonstrated by the local banks. The technical efficiency analysis based on the CRS assumption shows other results: the banks owned by the Nordic parent group and the branches have higher pure efficiency than local banks and have success at working at the right scale. Based on this, it stated that during the 2012–2016 period the larger Lithuanian banks (subsidiaries) applied a more appropriate business model than smaller (local) banks operating in Lithuania. Additionally, this research contributes to the scholarly literature in the field of determinants of bank business performance in concentrated markets dominated by foreign banks and, in particular, from one region. Full article

Hidden Markov model (HMM) is a statistical signal prediction model, which has been widely used to predict economic regimes and stock prices. In this paper, we introduce the application of HMM in trading stocks (with S&P 500 index being an example) based on the stock price predictions. The procedure starts by using four criteria, including the Akaike information, the Bayesian information, the Hannan Quinn information, and the Bozdogan Consistent Akaike Information, in order to determine an optimal number of states for the HMM. The selected four-state HMM is then used to predict monthly closing prices of the S&P 500 index. For this work, the out-of-sample $R_{\mathrm{OS}}^2$ , and some other error estimators are used to test the HMM predictions against the historical average model. Finally, both the HMM and the historical average model are used to trade the S&P 500. The obtained results clearly prove that the HMM outperforms this traditional method in predicting and trading stocks. Full article

This paper investigates the risk-return relations in Chinese equity markets. Based on a TARCH-M model, evidence shows that stock returns are positively correlated with predictable volatility, supporting the risk-return relation in both aggregate and sectoral markets. Evidence finds a positive relation between stock return and intertemporal downside risk, while controlling for sentiment and liquidity. This study suggests that the U.S. stress risk or the world downside risk should be priced into the Chinese stocks. The paper concludes that the risk-return tradeoff is present in the GARCH-in-mean, local downside risk-return, and global risk-return relations. Full article

This paper principally aims at examining the impact of capital requirements regulation on bank operating efficiency in Tanzania. The study employs bank level data for the period between 2009 and 2015. The findings show a positive and significant relationship between capital ratio and bank operating efficiency. This shows that commercial banks in Tanzania with more stringent capital regulations are more operationally efficient. This relationship proposes that capital adequacy does not only strengthen financial stability by providing a larger capital cushion but also improves bank operating efficiency by preventing a moral hazard problem between shareholders and debt-holders. This result may also imply that the increased regulations on capital requirements influence the bank’s decision to revisit their internal operations strategy in terms of strong corporate governance, risk assessment methods, credit evaluation procedures, employment of more qualified staffs, and enhanced internal control procedures. Another key finding is an inverse relationship between non-performing Loans (credit risk) and bank operating efficiency. The implication of this relationship may simply mean that the bank’s total loan and advances in combination with total deposit either due from customers or from other banks are of little importance in determining the operational efficiency of banks. This probably implies that the amount of money banks loan out is too excessive, which would attract a greater chance of default. The paper lays down some recommendations: first, banks in Tanzania are advised to invest in more advanced technological innovations to reduce the staff costs and other operating expenses to increase their operational efficiency; and, second, bank management is also advised to be more careful in the loan screening process to reduce the incidence of non-performing loans. Full article