Financial Market Dislocations

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Dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings. This study documents systematic financial market dislocations in world capital markets and the importance of their fluctuations for expected stock returns. Our novel, model-free measure of these dislocations is a monthly average of six hundred abnormal absolute violations of three textbook arbitrage parities in stock, foreign exchange, and money markets. We find that investors demand economically and statistically significant risk premiums to hold U.S. stocks and U.S. and international stock portfolios performing poorly during market dislocations.

Financial market dislocations are circumstances in which financial markets, operating under stressful conditions, cease to price assets correctly on an absolute and relative basis. The goal of this empirical study is to document the aggregate, time-varying extent of financial market dislocations in world capital markets and to investigate whether their fluctuations affect expected stock returns. The investigation of financial market dislocations is of pressing interest. When “massive” and “persistent,” these dislocations pose “a major puzzle to classical asset pricing theory” (Fleckenstein et al., 2010). The turmoil in both U.S. and world capital markets in proximity of the 2008 financial crisis is commonly referred to as a major “dislocation.” Regulators have recently begun to treat such dislocations as an important, yet not fully-understood source of financial fragility and economic instability when considering macroprudential regulation (Kashyap et al., 2010). Lastly, the recurrence of severe financial market dislocations over the last three decades (e.g., Mexico in 1994-1995; East Asia in 1997; LTCM and Russia in 1998; Argentina in 2001-2002) has prompted institutional investors to revisit their decision-making and risk-management practices. Download free Financial Market Dislocations.pdf here

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