This thesis presents three papers in the field of international finance and provides a study of the international capital flows from a macro-finance perspective. The first paper is an empirical investigation of the relative importance of hot money in bank credit and portfolio flows from the U.S. to 18 emerging markets over the period 1988-2012. We deploy state-space models à la Kalman filter to identify the unobserved hot money as the temporary component of each type of flow. The analysis reveals that the importance of hot money relative to the permanent component in bank credit flows has significantly increased during the 2000s relative to the 1990s. This finding is robust to controlling for the influence of push and pull factors in the two unobserved components. The evidence supports indirectly the view that global banks have played an important role in the transmission of the global financial crisis to emerging markets, and endorses the use of regulations to manage international capital flows. The second paper examines the role played by cross-border equity, bond and bank credit flows versus international trade in the transmission of the U.S. subprime crisis to equity markets worldwide. We estimate vector autoregressive models with exogenous global factors using monthly data on 36 emerging and developed countries. The results from an eclectic methodology that includes causality tests, generalized impulse responses and forecast error variance decompositions indicate that the subprime crisis is mostly transmitted through bank credit rather than portfolio flows and international trade. The results are robust to altering the exogenous versus endogenous vectors of variables, to measuring equity prices in U.S. dollars or local currency, to averaging the data across countries versus averaging the parameters from individual country estimation, and to redefining the start date of the crisis. The findings endorse the use of banking regulation and capital controls as part of the policy toolkit to limit financial vulnerability. Finally, the third paper examine the two steps and the prediction of Uncovered Equity Parity (UEP). Within a portfolio-rebalancing framework, UEP predicts that countries with strong equity markets should experience a currency depreciation, as higher total returns in domestic equity market will cause foreign investors to repatriate some of their investments to decrease their exchange rate exposure, leading to exchange rate depreciation. Using daily equity flow data including all the recorded trades of foreign investors for six Asian EMs from the 1990s to 2013, we find a positive rather than a negative relationship between currency and equity returns. We document that it is because the foreigners in aggregate chase returns rather than rebalance their portfolios in emerging markets, while foreign equity flows do cause exchange rate movements in the same direction. Thus, we unveil another side of UEP. Additionally, we find little evidence that foreign equity flows respond to past currency returns, suggesting that foreign equity investors only use local currency as a vehicle investing in emerging markets.

The aim of this thesis is to assess the integration of European electricity markets. An integrated market could help to improve security of supply, foster competition, and may also help to integrate renewables. After reviewing the literature and describing the context, three studies are reported as separate chapters, which besides the common underlying theme use novel econometric and statistical methodology for time series analysis. Chapter two examines electricity market integration in nine European spot markets between 2000 and 2013, and four forward markets between 2007 and 2012. In contrast to most previous studies, this study proposes that electricity price processes are time-varying, and assesses the potential impacts of special events. Spot prices are found to be fractionally integrated and mean-reverting processes whose parameters are time-dependent and associated with electricity market coupling initiatives or changes in interconnector capacity. Forward prices, in contrast, do not revert to the mean, and in general show more stable common long-run associations than electricity spot prices. Chapter three investigates the association between electricity market integration, fuel and carbon price developments during base and peak load hours from December 2005 to October 2013 for France, Nordpool and the UK. The local electricity mix and interconnection with adjacent markets are found to be associated with common price dynamics between electricity markets, as well as with electricity fuel and carbon prices. Chapter four studies the possible implications of Germany’s Nuclear Phase Out Act on the integration of EU’s electricity market. In 2011, Germany’s secure generating capacity decreased significantly after eight nuclear power plants were closed within a period of six months. The short-run interrelationships of electricity spot prices, from November 2009 to October 2012, with wind introduced by the German system, are modelled using multivariate generalised autoregressive conditional heteroscedasticity (MGARCH) models with dynamic correlations. In addition, a time-varying fractional cointegration analysis is conducted to identify any change in mean reversion and convergence of electricity spot prices. The results suggest unintended consequences from the policy: in the one-year period after the closures, the German market decoupled from the other markets and price volatility transmission increased.

This empirically motivated doctoral thesis investigates the impact of Federal Funds rate (FFR) surprises on asset prices between Jun-89 to Dec-12, with a focus on the effect of the 2007-2009 financial crisis on this relationship. This is an important question to evaluate because the Fed initially responded to the crisis by using conventional monetary policy (i.e. target FFR cuts) to influence financial, monetary and economic conditions in the broader macroeconomy. This was also the primary policy tool of the Fed throughout the majority of the crisis period (Sep-07 to Dec-08) and non-conventional monetary policy measures were only used when the target FFR approached the zero-lower bound. In Chapter 1 we outline the thesis and in Chapter 2 we review empirical studies related to this thesis. Chapter 3 is the first empirical chapter of this thesis in which we investigate the impact of FFR surprises on US stock returns. We demonstrate that a structural shift occurred during the recent crisis which significantly altered the US stock market response to FFR shocks. In particular, stock returns were shown to be associated with non-positive or negative responses to unexpected FFR cuts during the crisis. The lack of a positive stock response to FFR shocks during the crisis implies that unexpected FFR cuts ceased to be seen as good news by stock market investors, and were rather interpreted as signals from the Fed of worsening macro-financial conditions. We extend our empirical analysis to the US Treasury market and gold market in Chapter 4. Our estimates show that very short-term maturity (3-Month), longer-term (5-Year, 10-Year and 30-Year) maturity Treasury yields and gold returns were associated with significantly larger magnitude declines in response to unexpected FFR cuts during the crisis. The stronger response of these securities to FFR shocks during the crisis implies that unexpected FFR cuts signalled worsening future economic prospects and triggered a rebalancing of investment portfolios away from falling equities and towards these safe-haven assets. These cuts prompted significantly higher demand for highly liquid securities such as 3-Month T-Bills and gold. The stronger response of longer-term Treasuries implies that investors anticipated a prolonged downturn and increased demand for longer-term, lower-risk, safe-haven assets. Finally in Chapter 5 we consider the international context, investigating the transmission of FFR shocks to equity indices across 43 advanced and emerging market countries. We find substantial cross country heterogeneity in the responses of foreign equity index returns to FFR shocks outside the crisis, with positive stock responses to FFR shocks where significant. However, we find even greater heterogeneity in the responses of foreign equity indices to FFR shocks during the crisis, with an unexpected 1% FFR cut being associated with significant 2.53%-7.50% decline across the equity indices of 12 countries, and 2.79%-14.04% increases across the equity indices of 19 countries. Our estimates show that cross country heterogeneity in equity market responses to FFR shocks during the crisis period can only partly be explained in terms of real bilateral integration with the US economy, and find that external borrowing from the rest of the world is also an important determinant. Overall, our estimates in this thesis highlight the severity of the 2007-2009 crisis, reveal the limits of conventional monetary policy at the zero lower bound and are consistent with the Keynesian liquidity trap theory.

In this thesis, I study how information and asset market frictions can affect the investment and funding decisions of financial institutions, and their implications for the efficiency and stability of the financial system as a whole. The first chapter, Self-fulfilling fire sales, shows that while collateralised short-term debt mitigates individual borrowing firms’ incentives to take excessive risk, it also exerts pressure on the liquidity of the collateral asset market. When the asset market is not liquid enough, a vicious feedback loop between borrowers’ risk-taking incentives and expected asset fire-sale discount can cause instability in this secured funding market. Central bank intervention such as asset purchase is shown to be able to enhance stability and welfare. In the second chapter, Counter-cyclical foreclosure for securitisation, Jing Zeng and I study how information asymmetry in the mortgage securitisation process could distort the foreclosure policy of delinquent mortages. We show that banks would choose to commit to foreclose delinquent mortgages excessively in order to reduce the information friction in the securitisation process. This offers a potential explanation to the large number of foreclosures of delinquent mortgages in the U.S in the aftermath of the Subprime mortgage crisis in 2007-2009. The last chapter, Asset market runs and the collapse of debt maturity, shows that when market-makers have limited riskabsorbing capacity and there is uncertainty in the execution prices of sell orders, a borrower may want to shorten the debt maturity in order to allow his creditor to demand repayment and liquidate the collateral asset ahead of creditors of other firms in the case of default. This strategic shortening of debt maturity in equilibrium amplifies the borrowers risk of failing to roll-over their debt and leads to excessive asset liquidation.

This thesis contains three theory essays on the role of contracting in financial markets. The first essay, called Procyclical Promises, shows that in the presence of two contracting frictions—capital diversion and renegotiation—increasing the cyclicality of an entrepreneur’s output can increase his debt capacity with potentially important implications for the macroeconomy and government policy. The second essay, called The Downside of Public Information in Contracting, studies a principal-agent problem with a verifiable public signal. It demonstrates that when agents are competitive, decreasing the precision of the public signal can be Pareto improving in a wide class of environments. We apply the framework to a problem of delegated portfolio management and argue that our results suggest that regulators should insist that credit ratings agencies coarsen their ratings categories. The third essay, called Credit Market Competition and Corporate Investment, uses a general equilibrium framework to study the effect of the price and supply of credit on firms’ project choices. It shows that for only intermediate levels of credit market competition do firms choose efficient projects.

This thesis consists of an introductory chapter, three main chapters, and a concluding chapter. In Chapter 2, which was nominated for an EFMA 2014 Best Paper Award, I provide a novel risk-based explanation for the profitability of global momentum strategies. I show that the performance of past winners and losers is asymmetric in states of the global market upturns and downturns. Winners have higher downside market betas and lower upside market betas than losers, and hence their risks are more asymmetric. The winner-minus-loser (WML) momentum portfolios are exposed to the downside market risk, but serve as a hedge against the upside market risk. The high returns of the WML portfolios compensate investors for their high risk asymmetry. After controlling for this risk asymmetry, the momentum portfolios do not yield significant abnormal returns, and the momentum factor becomes insignificant in the cross-section. The two-beta CAPM with downside risk explains the cross-section of returns to global momentum portfolios well. In the third chapter, published in the Review of Finance and the winner of EFMA 2013 John Doukas Best Paper Award, I propose a new factor – the global downside market factor – to explain high returns to carry trades. I show that carry trades have high downside market risk, i.e. they crash systematically in the worst states of the world when the global stock market plunges or when a disaster occurs. The downside market factor explains the returns to currency portfolios sorted by the forward discount better than other factors previously proposed in the literature. GMM estimates of the downside beta premium are similar in the currency and stock markets, statistically significant and close to their theoretical value. I show that the high returns to carry trades are fair compensation for their high downside market risk. In the fourth chapter, I study whether or not countries‟ macroeconomic characteristics are systematically related to the downside market risk of their currencies. I find that the downside risk is strongly associated with the local inflation rate, real interest rate and net foreign asset 5 position. Currencies of countries with higher inflation and real interest rates and lower (negative) net foreign asset position (debtor countries) are more exposed to the downside risk whereas currencies of countries with low inflation and real interest rates and positive net foreign asset position (creditor countries) exhibit „safe haven‟ properties. Since inflation and real interest rates determine nominal interest rates which determinecurrency returns which, in turn, determine capital flows and net foreign asset positions, these macroeconomic variables are related. But the local real interest rate has the highest explanatory power in accounting for the cross-section of currency exposure to the downside risk. This suggests that the direction of currency trading is the reason why some currencies are exposed to the downside risk more than others. High currency downside risk is a consequence of investments in high-yield risky currencies and flight from them in „hard times‟. Currencies of low-yield creditor countries, on the contrary, provide a hedge in „hard times‟ because capital flies back to them. Currency exposure to the downside market risk has increased significantly in the 2000s when the volume of currency trading by institutional investors increased.

This study addresses three distinct but interrelated areas in the micro insurance sector in Tanzania a) demand perspectives of micro insurance in the informal sector b) examining strengths and weakness of current risk coping strategies in the informal sector c) examining household’s characteristics that influence demand for micro insurance. The study analyses data from a primary survey and focus group discussion derived from informal sector households’ members of the VIBINDO society in three districts of Ilala, Kinondoni and Temeke in Dar es Salaam. The analysis involves three steps; first, household’s major risk exposures were analysed, secondly risk coping strategies which were in place were examined and thirdly, a probit regression analysis was conducted to establish the relationship between households’ characteristics and demand for micro insurance in the informal sector. There are three major findings from this study: Firstly, the results indicate that employment, marital status, use of financial services, education, risk exposure and insurance knowledge are significant determinants of micro-insurance demand. Insurance knowledge and trust of insurers were found to have a positive and significant impact on the demand for micro insurance. Contrary to expectations, the empirical analysis shows that income is a significant determinant with a negative impact on micro insurance demand. Secondly, the findings suggest that demand for micro insurance in the informal sector depends on the competitive advantage between formal insurance services and available informal techniques. Informal techniques have important informational advantages due to their close physical proximity and frequent, repeated interactions. This implies that some inferences can be drawn from the design and development of micro insurance. The analysis highlights different approaches to be taken by insurers in designing micro insurance products. Thirdly, there is evidence to suggest that pre-existing informal sharing networks affect demand for micro insurance. The low demand for micro insurance can be explained by available informal arrangements which are characterized by closely knit social networks and groups that provide security in exchange for loyalty to the group. Also, uncertainty avoidance culture is low within the households in Tanzania, hence households seem to be more tolerate to different situations. The findings recommend strategies for micro insurance expansion in the informal sector, which is therefore useful for the expansion of financial services.

Given the growing importance of securitisation to financial stability, it is surprising that empirical studies on the role of the US structured finance market in the recent crisis have been relatively sparse. To fill this gap, this thesis studies the US structured finance market (tracked by the ABX indices) and addresses various important research questions specific to the recent 2007 to 2009 financial crisis. First, I contribute to the contagion literature by extending Longstaff’s (2010) investigation to an international market perspective. Evidence of contagion from the ABX indices to the G5 international equity and government bond markets via the funding illiquidity and credit risk channels during the subprime crisis is documented. Second, I formulate a multifactor model with crisis interaction effects and document significant increases in the ABX AAA factor loadings during the subprime crisis, which is consistent with contagion. My cross-sectional pricing tests show that the ABX AAA factor significantly explains the cross-section of expected returns during the subprime crisis; that is, the impact of contagion on the US equity market was reasonably systematic. I compute a simple statistic that gauges the degree of the stocks’ exposure to the ABX innovations in each month and find that the exposure spiked in February, July and October 2007 and in February, July and November 2008. Third, I investigate whether the US bank holding companies’ fundamental characteristics determine bank equity risks during the recent crisis. I depart from prior studies and consider bank equity risks relating to the banks’ exposure to the ABX innovations, the asset-backed money market and the market wide default risk in a variance decomposition. My study establishes the link between the banks’ fundamental and equity risks, and shows that banks’ regulatory capital requirement is an effective means to limit banks’ exposure to systemic risks in relation to funding illiquidity. Lastly, I document compelling evidence of quarterly bank stock return predictability based on variables relating to banks’ profitability, loan asset credit quality, capital adequacy and equity risks over the 2006 to 2011 period. By studying the turnover ratios and order flows, I show that bank stocks with weaker fundamentals and smaller size were traded more intensely in the following quarter while the higher trading activity was dominated by selling pressure. The evidence lends support to my ‘fire sale’ or ‘flight-to-safety’ hypothesis and reveals that the banks’ fundamental variables and size were the major criteria used by investors in formulating their ‘flight’ decisions during the recent crisis.

Customer satisfaction (CS) is critical to success in banking. However, there is little agreement on which antecedents can be employed to achieve it. Moreover, in the context of Islamic banking, religiosity plays a major role in affecting customers’ choice of bank and banking satisfaction. In response, this thesis developed an Islamic religiosity scale measurement and an integrated model of customer satisfaction for Islamic credit-card users. In particular, this thesis sought to investigate the role of religiosity and antecedents of Islamic credit-card users’ satisfaction. Furthermore, it presented and discussed empirical findings from mixed methods approach employing semi-structured interviews of seven respondents and an online survey of 560 credit-card users in Malaysia. The study used confirmatory and structural equation modelling to examine the survey data. The findings of this thesis largely support the hypothesised relationships proposed in the theoretical model. Specifically, the results revealed that the functional service quality (FSQ), technical service quality (TSQ) and the religious and ethical service quality (RESQ) are crucial and differ in affecting customer satisfaction. The results also provide strong evidence that religiosity moderates between the antecedents and customer satisfaction. Most importantly, Shari’ah compliance and ethical dimensions (constructs in RESQ) are necessary determinants of Islamic credit-card users’ satisfaction. This thesis contributes to the existing theoretical and practical knowledge by providing, for the first time, an Islamic religiosity scale measurement. Secondly, evidence is presented that religiosity plays a significant contribution towards the customer satisfaction model. Thirdly, the integration of FSQ, TSQ and RESQ creates a comprehensive Islamic customer satisfaction model. Fourthly, since the integrated model involves religious factors (i.e. Shari’ah compliance), religiosity contributes to the variation of customer satisfaction. The inclusion of Shari’ah compliance, ethical dimensions, technology and communication as first order constructs and FSQ, TSQ and RESQ as second order constructs contribute to the body of customer satisfaction and Islamic banking literature. The findings imply the need for the banks to lever on the key antecedents of customer satisfaction, which include Shari’ah compliance and ethical dimensions.

The establishment and operation of Islamic banking and finance is governed by Shari’ah principles. These specific underlying principles give a new dimension to its governance structure, which is known as Shari’ah Governance. The aim of this research is to examine the theoretical and practical aspects of problems and challenges facing Islamic banking and finance in Malaysia. The study focuses on four main issues: legal and regulatory framework, Shari’ah compliance, management, and accounting. In order to achieve the objectives, this study surveys different groups of respondents who are involved in the operation of Islamic banking and finance, using semi-structured interviews. The key respondents are members of the Shari’ah Committee, Shari’ah Officers and Chief Executive Officers (CEO). The major problems and challenges which emerged from the interview findings are the influence of the dual-banking environment, lack of support from the regulatory framework related to products and services, Shari’ah non-compliance, operation and management, lack of expertise in human capital, lack of accountability, and lack of influence of accounting practices and auditing. The majority of key respondents explicitly highlighted these findings. According to agency theory, accountability is the primary corresponding function for decision making in the banking system; however, this does not appear to be transparent in the Islamic banking sector. As in most contexts of Islamic banking, inadequate accounting practices are also considered to be the major challenge that Islamic banking face. Regarding this challenge, the Islamic banking system has not achieved the ultimate objective in implementing Shari’ah in the banking system. However, with constraint and uncertainty, several efforts have been made to achieve a homogeneous structure. Radical innovation of accounting practices that support Shari’ah could be the alternatives to assist the Islamic banking system to become more efficient and effective. Theories such as agency theory, stakeholder theory and institutional theory could serve as pillars to support the implementation in order to enhance Shari’ah activities. In addition, the explanation of agent morality of the stakeholder model is also important, as Islamic banking personnel need to uphold Shari’ah principles and commercial viability. Furthermore, institutional theories are employed in the explanation of the organisational behaviour of IBs.