Recent iber_cfrmrc_rw items

Minimizing Shortfall (revised)

Wed, 24 Jul 2013 00:00:00 +0000

(from the introduction...)

In this paper, we combine the innovations described above in an empirical study of expected shortfall optimization with Factor-Based Extreme Risk. We avoid the issue of forecasting mean return by comparing minimum expected shortfall to minimum variance portfolios. Our study is carried out for the US, UK, and Japanese equity markets and it uses Barra Style Factors (Value, Growth, Momentum, etc.). We show that minimizing expected shortfall generally improves performance over minimizing variance, especially during down-markets, over the period 1985-2010. The outperformance of expected shortfall is due to intuitive tilts towards protective factors like Value, and away from aggressive factorslike Growth and Momentum. The outperformance is largest for the expected shortfall at relatively low confidence levels, which measures distributional asymmetry rather than the extreme losses.

Finance at Center Stage: Some Lessons of the Euro Crisis

Wed, 24 Jul 2013 00:00:00 +0000

(from the introduction...)

Finance and financial markets were at the heart of the global economic crisis

that began in August 2007. Despite having subsided elsewhere by 2010, the global crisis

left an ongoing legacy of turbulence in the euro zone. My argument in this essay is that

the euro zone’s continuing turmoil, like that of the world economy in 2007‐09, is rooted

in financial vulnerabilities that were not well envisioned in the defenses set up by EMU’s

architects. If the euro is to survive, EMU’s institutions must evolve to overcome these

vulnerabilities. The necessary changes will have profound effects on the future shape of EMU, effects significant enough to require changes in EU political arrangements

alongside more technical financial reforms.

In Search of a Statistically Valid Volatility Risk Factor

Wed, 24 Jul 2013 00:00:00 +0000

Theory predicts that aggregate volatility ought to be a priced risk factor. In an influential study with more than 1000 citations on Google Scholar, Ang, Hodrick, Xing, and Zhang (2006) propose an ex post factor, FVIX, intended as a proxy for aggregate volatility risk. Their test validating FVIX relies on an OLS regression

of portfolio excess returns on FVIX and other independent variables over the data period February 1986 - January 2001. October 1987 is an outlier, in which FVIX exhibits a 26-sigma deviation. The inclusion of this outlier results in a reduction of the regression standard error by more than a factor of two, creating the appearance of statistical signicance when none is present. We explain how standard statistics

can be used to assess the suitability of a dataset for OLS regression.

Self-Enforcing Clawback Provisions in Executive Compensation

Wed, 24 Jul 2013 00:00:00 +0000

A clawback provision is the right of a firm to recover from an executive’s compensation as the result of triggering events, such as a financial restatement. We argue that the adoption of clawback provisions may exacerbate a manager’s incentive to avoid financial restatements via earnings management. Only when the accounting verifiability is high, making earnings management very costly, can clawback provisions completely eliminate the manager’s incentive to misreport ex-ante; otherwise, clawback provisions stipulate a reduction of future executive compensation in the event of a financial restatement. We show firms still benefit from implementing clawback provisions, while earnings management is costless. This result may explain why companies voluntarily adopt clawback provisions, in spite of the detrimental effect of earnings management.

Stories of the Twentieth Century for the Twenty-First

Wed, 24 Jul 2013 00:00:00 +0000

A key precursor of twentieth-century financial crises in emerging and advanced economies alike was the rapid buildup of leverage. Those emerging economies that avoided leverage booms during the 2000s also were most likely to avoid the worst effects of the twenty-first century's first global crisis. A discrete-choice panel analysis using 1973-2010 data suggests that domestic credit expansion and real currency appreciation have been the most robust and signicant predictors of financial crises, regardless of whether a country is emerging or advanced. For emerging economies, however, higher foreign exchange reserves predict a sharply reduced probability of a subsequent crisis.

Efficient Monte Carlo Counterparty Credit Risk Pricing and Measurement

Wed, 24 Jul 2013 00:00:00 +0000

Counterparty credit risk (CCR), a key driver of the 2007-08 credit crisis, has become one of the main focuses of the major global and U.S. regulatory standards. Financial institutions invest large amounts of resources employing Monte Carlo simulation to measure and price

their counterparty credit risk. We develop efficient Monte Carlo CCR frameworks by focusing on the most widely used and regulatory-driven CCR measures: expected positive exposure (EPE), credit value adjustment (CVA), and effective expected positive exposure (eEPE). Our numerical examples illustrate that our proposed efficient Monte Carlo estimators outperform the existing crude estimators of these CCR measures substantially in terms of mean square error (MSE). We also demonstrate that the two widely used sampling methods, the so-called Path Dependent Simulation (PDS) and Direct Jump to Simulation date (DJS), are not equivalent in that they lead to Monte Carlo CCR estimators which are drastically different in...

Equity Risk Premium and Insecure Property Right

Wed, 24 Jul 2013 00:00:00 +0000

How much of the equity risk premium puzzle can be attributed to the insecure property rights of shareholders? This paper develops a version of the CCAPM with insecure property rights (stochastic taxes). The model implies that the current expected equity premium can be reconciled with a coefficient of relative risk aversion of3:76, thus resolving the equity premium puzzle.

Bubbling with Excitement: An Experiment

Wed, 24 Jul 2013 00:00:00 +0000

In an experimental setting, we study the role of emotions in markets. Our experimental market is modeled on those of Smith, Suchanek, and Williams (1988) and Caginalp, Porter, and Smith (2001). Participants take part in a laboratory market in which they trade a risky asset over a computer network. Prior to trading, they watch short videos that are exciting and upbeat—chase scenes; neutral—segments from a historical documentary; fearful—scenes from a horror movie; or sad—scenes from a drama. Larger asset pricing bubbles develop in experimental markets run subsequent to the exciting videos relative to the other three conditions. The differences in the magnitude and amplitude of the bubbles are both economic and statistically significant. A follow-up study indicates that the phenomenon may be explained by excited people’s greater inclination to extrapolate past positive market trends into future asset prices.

Review of "Counterparty Credit Risk by Jon Gregory"

Wed, 24 Jul 2013 00:00:00 +0000

Review of "Counterparty Credit Risk by Jon Gregory"

Contingent Convertible Bonds: Pricing, Dilution

Wed, 24 Jul 2013 00:00:00 +0000

Contingent Convertible Bonds: Pricing, Dilution

Improving the Asmussen-Kroese Type Simulation Estimators

Wed, 24 Jul 2013 00:00:00 +0000

Asmussen-Kroese [1] Monte Carlo estimators of P(Sn > u) and P(SN > u) are known to work well in rare event settings when Sn is the sum of n i.i.d. heavy-tailed random variables, and N is a non-negative integer-valued random variable independent of the Xi. In this paper we show how to improve the Asmussen-Kroese estimators of both probabilities when the Xi are non-negative. We also apply our ideas to estimate the quantity E[(SN ? u)+].

When did the dollar overtake sterling as the leading international currency? Evidence from the bond markets (revised)

Wed, 24 Jul 2013 00:00:00 +0000

This paper offers new evidence on the emergence of the dollar as the leading international currency, focusing on its role as currency of denomination in global bond markets. We show that the dollar overtook sterling much earlier than commonly supposed, as early as in 1929. Financial market development appears to have been the main factor helping the dollar to surmount sterling’s head start. The finding that a shift from a unipolar to a multipolar international monetary and financial system has happened before suggests that it can happen again. That the shift occurred earlier than commonly believed suggests that the advantages of incumbency are not all they are cracked up to be. And that financial deepening was a key determinant of the dollar’s emergence points to the challenges facing currencies aspiring to international status.

Review of Daniel Kahneman's "Thinking, Fast and Slow"

Wed, 24 Jul 2013 00:00:00 +0000

Review of Daniel Kahneman's "Thinking, Fast and Slow"

Improving the Normalized Importance Sampling Estimator

Wed, 24 Jul 2013 00:00:00 +0000

The normalized importance sampling estimator allows the target density f to be known only up to a multiplicative constant. We indicate how it can be derived by a delta method based approximation of a Rao-Blackwellized acceptance rejection estimator. Using additional terms in the delta method then results on a new estimator that also only requires f to be known only up to a multiplicative constant. Numerical examples indicate that the new estimator usually outperforms the normalized importance sampling estimator in terms of mean square error.

A Comment on \The Cross-Section of Volatility and Expected Returns": The Statistical Signi

Wed, 24 Jul 2013 00:00:00 +0000

A Comment on \The Cross-Section of Volatility and Expected Returns": The Statistical Signi

The Equity Risk Premium Puzzle: A Resolution �The Case for Real Estate

Wed, 24 Jul 2013 00:00:00 +0000

This paper examines and estimates the equity risk premium for securitized real estate (U.S. Real Estate Investment Trusts-REITs). By introducing stochastic taxes for equity REITs shareholders, the analysis demonstrates that the current expected after-tax risk premium for REITs generate a reasonable coe¢ cient of relative risk aversion. Employing a range of plausible stochastic tax burdens, the REITs shareholders’ coefficient of relative risk aversion is likely to fall within the interval from 4.3 to 6.3, a value signi…cantly lower than those reported in most of the prior studies for the general stock market.

Will My Risk Parity Strategy Outperform?

Wed, 24 Jul 2013 00:00:00 +0000

Will My Risk Parity Strategy Outperform?

Wed, 24 Jul 2013 00:00:00 +0000

Will My Risk Parity Strategy Outperform?

Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA

Wed, 24 Jul 2013 00:00:00 +0000

Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA

Conditional Risk Premia in Currency Markets and Other Asset Classes

Wed, 24 Jul 2013 00:00:00 +0000

The downside risk CAPM (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly explain

the cross section of equity, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specic asset class fail to jointly price other asset classes.

Risk Without Return

Wed, 24 Jul 2013 00:00:00 +0000

Risk-only investment strategies have been growing in popularity as traditional investment strategies have fallen short of return targets over the last decade. However, risk-based investors should be aware of four things. First, theoretical considerations and empirical studies show that apparently distinct risk-based investment strategies are manifestations of a single eect. Second, turnover and associated transaction costs can be a substantial drag on return. Third, capital diversication benefits may

be reduced. Fourth, there is an apparent connection between performance and risk

diversication. To analyze risk diversification benets in a consistent way, we introduce the Risk Diversification index (RDI) which measures risk concentrations and complements the Herndahl-Hirschman index (HHI) for capital concentrations.

Incentive Thresholds, Risk-Taking, and Performance. Evidence from Hedge Funds

Wed, 24 Jul 2013 00:00:00 +0000

Incentive Thresholds, Risk-Taking, and Performance. Evidence from Hedge Funds

Allocating Assets in Climates of Extreme Risk

Tue, 31 May 2011 00:00:00 +0000

As predatory financial markets dismembered Lehman Brothers in the autumn of 2008, panicked investors took refuge in US Treasuries. However, the rich returns to US sovereign bonds were not evenly distributed across the market. Prices of Treasury Inflation Protected Securities (TIPS), for which the principal and interest payments are indexed to the CPI, fell dramatically as their nominal counterparts rose in value. Near-term “breakeven” or “expected” inflation, which is the difference between nominal and real yields, plummeted to 6.5

Allocating Assests in Climates of Extreme Risk

Mon, 9 May 2011 00:00:00 +0000

Allocating Assests in Climates of Extreme Risk

Minimizing Shortfall

Mon, 9 May 2011 00:00:00 +0000

Despite the increasing sophistication of Finance in the past 30 years, quantitative tools for building portfolios remain entrenched in the paradigm proposed by Markowitz in 1952; these tools offer investors a trade-off between mean return and variance. However, Markowitz himself was not satisfied with variance, which penalizes gains and losses equally. Instead he preferred semi-deviation, which only penalizes losses.

The U.S. Equity Return Premium: Past, Present and Future

Mon, 17 May 2010 00:00:00 +0000

For more than a century, diversified long-horizon investments in America's stock market have consistently received much higher returns than investors in bonds: a return gap averaging 6 percent per year. An enormous amount of creative and ingenious work by a great many economists has gone into seeking explanations for the so-called "equity premium return puzzle," but so far without a fully satisfactory answer. We first review the facts about the equity premium and then discuss a range of explanations that have been proposed. We conclude that the equity premium puzzle has not been solved: it remains a puzzle. And we anticipate that the equity return premium will continue, albeit at a smaller level than in the past--perhaps four percent per year.

Contingent Convertible Bonds and Capital Structure Decisions

Mon, 17 May 2010 00:00:00 +0000

This paper provides a formal model of contingent convertible bonds (CCBs), a new instrument offering potential value as a component of corporate capital structures for all types of �firms, as well as being considered for the reform of prudential bank regulation following the recent �financial crisis. CCBs are debt instruments that automatically convert to equity if and when the issuing �firm or bank reaches a speci�fied level of �financial distress. CCBs have the potential to avoid bank bailouts of the type that occurred during the subprime mortgage crisis when banks could not raise suffcient new capital and bank regulators feared the consequences if systemically important banks failed. While qualitative discussions of CCBs are available in the literature, this is the �first paper to develop a formal model of their properties. The paper provides analytic propositions concerning CCB attributes and develops implications for struc- turing CCBs to maximize their general bene�fits...

New Performance - Vested Stock Option Themes

Mon, 17 May 2010 00:00:00 +0000

In the present paper, we advocate two effective non-traditional performance-based stock option schemes: Parisian and Asian executives’ stock option plans. Under a Parisian option scheme, the stock price should have outperformed a certain stock price for a fixed length of time. Under an Asian scheme, the executives’ compensation is coupled with the average performance of the stock price. Both schemes make the manipulation through the executives less likely. In the Parisian scheme, it can be achieved by setting the length of excursion sufficiently long and in the Asian scheme, by requiring the average rate of return of the stock to exceed a relatively high fixed rate of return. We focus on the valuation of these new performance-vested stock options and conduct some numerical analyses based on the valuation formulae we obtain.

Contractibility and the Design of Research Agreements

Mon, 17 May 2010 00:00:00 +0000

We analyze how contractibility affects contract design. A major concern when designing research agreements is that researchers may use their funding to subsidize other projects. We show that, when research activities are not contractible, an option contract is optimal. The financing firm obtains the option to terminate the agreement and, in case of termination, broad property rights. The threat of termination deters researchers from cross-subsidization, and the cost of exercising the termination option deters the financing firm from opportunistic termination. We test this prediction using 580 biotechnology research agreements. Contracts with termination options are more common when research is non-contractible.

Do Security Analysts Speak In Two Tongues?

Mon, 17 May 2010 00:00:00 +0000

Why do security analysts issue overly positive recommendations? We propose a novel empirical strategy to assess the relative importance of the leading explanations: strategic distortion, which reflects incentives to trigger small-investor purchases and please management, and non-strategic distortion, which reflects genuine over-optimism, due to self-selection or credulity. We exploit the concurrent issuance of recommendations and earnings forecasts by the same analyst to distinguish those motivations. While non-strategic distorters express their positive view both in recommendations and in forecasts, strategic distorters issue overly positive recommendations but slightly more negative (“beatable”) forecasts. We find that affiliated analysts who have the most positive recommendations outstanding make the most negative forecasts. The same does not hold for unaffiliated analysts. Affiliated analysts are also more likely to distort forecasts downwards just before earnings announcements,...

Contingent Convertible Bonds and Capital Structure Decisions

Mon, 29 Mar 2010 00:00:00 +0000

This paper provides a formal model of contingent convertible bonds (CCBs), a new instru- ment o�ffering potential value as a component of corporate capital structures for all types of �rms, as well as being considered for the reform of prudential bank regulation following the recent �financial crisis. CCBs are debt instruments that automatically convert to equity if and when the issuing �rm or bank reaches a speci�ed level of �financial distress. CCBs have the potential to avoid bank bailouts of the type that occurred during the subprime mortgage crisis when banks could not raise sufficient new capital and bank regulators feared the consequences if systemically important banks failed. While qualitative discussions of CCBs are available in the literature, this is the �first paper to develop a formal model of their properties. The paper provides analytic propositions concerning CCB attributes and develops implications for struc- turing CCBs to maximize their general benefi�ts...

Lenders of Last Resort in a Globalized World

Wed, 10 Mar 2010 00:00:00 +0000

The recent financial crisis teaches important lessons regarding the lender-of-last resort function. Large swap lines extended in 2007-08 from the Federal Reserve to other central banks show that the classic concept of a national last-resort lender fails to address key vulnerabilities in a globalized financial system with multiple currencies. What system of emergency international financial support will best help to minimize the likelihood of future economic instability? Acting alongside national central banks, the International Monetary Fund has a key role to play in the constellation of lenders of last resort. As the income-level and institutional divergence between emerging and mature economies shrinks over time, the IMF may even evolve into a global lastresort lender that channels central bank liquidity where it is needed. The IMF’s effectiveness would be greatly enhanced by several complementary reforms in international financial governance, though some of these appear...

Fragility of CVaR in portfolio optimization

Wed, 10 Mar 2010 00:00:00 +0000

Abstract We evaluate conditional value-at-risk (CVaR) as a risk measure in data-driven portfolio optimization. We show that portfolios obtained by solving mean-CVaR and global minimum CVaR problems are unreliable due to estimation errors of CVaR and/or the mean, which are aggravated by optimization. This prob- lem is exacerbated when the tail of the return distribution is made heavier. We conclude that CVaR, a coherent risk measure, is fragile in portfolio optimization due to estimation errors.

Exit Options and Dividend Policy under Liquidity Constraints

Wed, 10 Mar 2010 00:00:00 +0000

We introduce a post-entry liquidity constraint to the standard model of a …rm with stochastic cash ‡ow and irreversible exit decision. We assume that a …rm with no cash holdings and negative cash ‡ow is forced to exit regardless of its future prospects. This creates a precautionary motive for holding cash, which must be traded off against the liquidity cost of holding cash. We characterize the optimal exit and dividend policy and analyze numerically its comparative statics properties. The …rm pays dividends when it is in a sufficiently strong position in terms of cash ‡ow and cash holdings, and the …rm almost surely exits voluntarily to pre-empt forced exit. The direct effect of the liquidity constraint is to impose inefficient exit, but in industry equilibrium it also creates a price distortion that leads to ineffi cient survival. (D81, D92, G35)

An Equilibrium Pricing Model for Weather Derivatives in a Multi-commodity Setting

Wed, 10 Mar 2010 00:00:00 +0000

Many industries are exposed to weather risk. Weather derivatives can play a key role in hedging and diversifying such risk because the uncertainty in a company’s profit function can be correlated to weather condition which affects diverse industry sectors differently. Unfortunately the weather derivatives market is a classical example of an incomplete market that is not amenable to standard methodologies used for derivative pricing in complete markets. In this paper, we develop an equilibrium pricing model for weather derivatives in a multi-commodity setting. The model is constructed in the context of a stylized economy where agents optimize their hedging portfolios which include weather derivatives that are issued in a fixed quantity by a financial underwriter. The supply and demand resulting from hedging activities and the supply by the underwriter are combined in an equilibrium pricing model under the assumption that all agents maximize some risk averse utility function....

A Multi-period Equilibrium Pricing Model of Weather Derivatives

Wed, 10 Mar 2010 00:00:00 +0000

The prevalence of commercial activities whose profit and cost are correlated with weather risk makes weather derivatives valuable financial instruments that enable hedging of price or volumetric (quantity) risk in many industries. This paper proposes a multi-period equilibrium pricing model for weather derivative. In our stylized economy representative agents of weather-sensitive industries optimizes their hedging portfolios that drive the supply and demand for weather derivative which are dynamically determined based on a utility indifference pricing framework. At equilibrium the weather derivative market will be cleared and their market price can be obtained. Numerical examples illustrate the equilibrium prices and optimal choices for the weather derivative as function of the correlation between weather indices and demand for the underlying commodity. We also demonstrate the benefit of multiple trading opportunities which allows rebalancing of the hedging portfolio prior...

Is The Potential For High Investor Leverage A Threat To Social Security Privatization?

Wed, 10 Mar 2010 00:00:00 +0000

How risky and expensive it would be to insure a long-term individual Social Security account invested in stocks against the risk that the portfolio’s value would collapse? This paper uses a particular metric to evaluate this risk and cost. This metric is a long-term put option written on such a portfolio. The answer is that for reasonable parameters the Black-Scholes price of such a put option is surprisingly low: just 2-4% of original investment.

Equity Risk Premium and Insecure Property Rights

Wed, 10 Mar 2010 00:00:00 +0000

How much of the equity risk premium puzzle can be attributed to the insecure property rights of shareholders? This paper develops a version of the CCAPM with insecure property rights. The model implies that the current expected equity premium can be reconciled with a coefficient of risk aversion of 3.76, thus resolving the equity premium puzzle.

Piercing the Veil of Ignorance

Tue, 9 Mar 2010 00:00:00 +0000

Theories of justice in the spirit of Harsanyi and Rawls argue that fair-minded people should aspire to make choices for society — that is, for themselves and for others — as if in the original position, behind a veil of ignorance that prevents them from knowing their own social and economic positions in society. While the original position is a purely hypothetical situation, developed as a thought experiment, the main result of this paper is that (under certain assumptions) preferences — hence choices — behind the veil of ignorance are determined by preferences in front of the veil of ignorance. This linkage between preferences behind and in front of the veil of ignorance has implications for distributive theories of justice and for theories of choice.

Estimating Ambiguity Aversion in a Portfolio Choice Experiment

Tue, 9 Mar 2010 00:00:00 +0000

We report a laboratory experiment that enables us to estimate parametric models of ambiguity aversion at the level of the individual subject. We use two main specifications, a “kinked” specification that nests Maxmin Expected Utility, Choquet Expected Utility, α-Maxmin Expected Utility, and Contraction Expected Utility and a “smooth” specification that nests the various theories referred to collectively as Recursive Expected Utility. Our subjects solved a series of portfolio-choice problems. The assets are Arrow securities corresponding to three states of nature, where the probability of one state is known and the remaining two are ambiguous. The sample exhibits considerable heterogeneity in preferences, as captured by parameter estimates. Nonetheless, there exists a strong tendency to equalize the demands for the securities that pay off in the ambiguous states, a feature more easily accommodated by the kinked specification than by the smooth specification. We also find that...

Interest Rate Conundrum

Tue, 9 Mar 2010 00:00:00 +0000

In June of 2004 the Fed began relentlessly tightening policy. They raised the Federal Funds Target (Target) from 1% to 5 1/4% in 1/4% increments at seventeen consecutive meetings. While short rates dutifully followed the Target up, long maturity rates actually fell. Alan Greenspan in 2005 Congressional testimony labeled the strange behavior of the spread between long rates and the Target a “conundrum”. This paper examines the conundrum. We present robust empirical evidence that the increase in foreign holdings of US Treasury bonds explains at least half of the decline in long maturity rates. Foreign holdings of US Treasury debt with a maturity over one year grew from 20% in 1994 to 57% in 2007.

The Interest Rate Conundrum

Sat, 1 Aug 2009 00:00:00 +0000

In June of 2004 the Fed began relentlessly tightening policy. They raised the Federal Funds Target (Target) from 1% to 5 1/4% in 1/4% increments at seventeen consecutive meetings. While short rates dutifully followed the Target up, long maturity rates actually fell. Alan Greenspan in 2005 Congressional testimony labeled the strange behavior of the spread between long rates and the Target a "conundrum". This paper examines the conundrum. We present robust empirical evidence that the increase in foreign holdings of US Treasury bonds explains more than half of the decline in long maturity rates. Foreign holdings of US Treasury debt with a maturity over one year grew from 20% in 1994 to 57% in 2007.

Is The Potential For High Investor Leverage A Threat To Social Security Privatization?∗

Mon, 8 Sep 2008 00:00:00 +0000

The U.S. Equity Return Premium: Past, Present and Future

Mon, 8 Sep 2008 00:00:00 +0000

(Introduction, initial paragraphs) For more than a century, diversified longhorizon investors in America’s stock market have invariably received much higher returns than investors in bonds: a return gap averaging some six percent per year that Rajnish Mehra and Edward Prescott (1985) labeled the “equity premium puzzle.” The existence of this equity return premium has been known for generations: more than eighty years ago financial analyst Edgar L. Smith(1924) publicized the fact that longhorizon investors in diversified equities got a very good deal relative to investors in debt: consistently higher longrun average returns with less risk. It was true, Smith wrote three generations ago, that each individual company’s stock was very risky: “subject to the temporary hazard of hard times, and [to the hazard of] a radical change in the arts or of poor corporate management.” But these risks could be managed via diversification across stocks: “effectively eliminated through the application...

Principle-agent Incentives, Excess Caution, and Market Inefficiency: Evidence from Utility Regulation

Mon, 14 Jan 2008 00:00:00 +0000

Regulators and firms often use incentive schemes to attract skillful agents and to induce them to put forth effort in pursuit of the principals’ goals. Incentive schemes that reward skill and effort, however, may also punish agents for adverse outcomes beyond their control. As a result, such schemes may induce inefficient behavior, as agents try to avoid actions that might make it easier to directly associate a bad outcome with their decisions. In this paper, we study how such caution on the part of individual agents may lead to inefficient market outcomes, focusing on the context of natural gas procurement by regulated public utilities. We posit that a regulated natural gas distribution company may, due to regulatory incentives, engage in excessively cautious behavior by foregoing surplus increasing gas trades that could be seen ex post as having caused supply curtailments to its customers. We derive testable implications of such behavior and show that the theory is supported...

A Class of Singular Control Problems and the Smooth Fit Principle

Wed, 5 Dec 2007 00:00:00 +0000

This paper analyzes a class of singular control problems for which value functions are not necessarily smooth. Necessary and su±cient conditions for the well-known smooth ¯t principle, along with the regularity of the value functions, are given. Explicit solutions for the optimal policy and for the value functions are provided. In particular, when payo® functions satisfy the usual Inada conditions, the boundaries between action and no-action regions are smooth and strictly monotonic as postulated and exploited in the existing literature (Dixit and Pindyck (1994); Davis, Dempster, Sethi, and Vermes(1987); Kobila (1993); Abel and Eberly (1997); Âksendal (2000); Scheinkman and Zariphopoulou (2001); Merhi and Zervos (2007); Alvarez (2006)). Illustrative examples for both smooth and non-smooth cases are discussed, to highlight the pitfall of solving singular control problems with a priori smoothness assumptions.

Time-Varying Risk Premia and Stock Return Autocorrelation

Wed, 5 Dec 2007 00:00:00 +0000

Autocorrelation in stock returns is one important measure of the efficiency of securities markets pricing. Autocorrelation may be a sign of genuine pricing inefficiency: partial price adjustment (PPA), in which trades occur at prices that do not fully reflect the available information. However, autocorrelation may also arise from three other sources: bid-ask bounce (BAB), nonsynchronous trading (NT), and time-varying risk premia (TVRP). TVRP is not an indication of inefficient pricing. It can arise in a securities market equilibrium because the equilibrium returns of the available investments change over time; in particular, the presence of TVRP is entirely compatible with the absence of arbitrage in securities markets. Anderson, Eom, Hahn and Park (2006) provide methods for identifying a portion of the autcorrelation that can only be attributable to PPA and TVRP. This paper provides bounds on TVRP, as a function of the return period, the time horizon over which the autocorrelations...

Optimal Spot Market Inventory Strategies in the Presence of Cost and Price Risk

Wed, 5 Dec 2007 00:00:00 +0000

We consider a ¯rm facing random demand at the end of a single period of random length. At any time during the period, the ¯rm can either increase or decrease inventory by buying or selling on a spot market where price °uctuates randomly over time, and the revenue the ¯rm gets by meeting demand at the end of the period is a function of the spot market price at that time. We ¯rst demonstrate that this control problem is equivalent to a singular control problem of higher dimensions. We then use this insight combined with a novel control-theoretic approach to show that the optimal policy is completely characterized by a simple price-dependent two threshold policy. In a series of computational experiments, we explore the value of actively managing inventory during the period rather than making a purchase decision at the start of the period,and then waiting for demand.

Stock Return Autocorrelation is Not Spurious

Wed, 5 Dec 2007 00:00:00 +0000

We decompose stock return autocorrelation into spurious components—the nonsynchronous trading effect (NT) and bid-ask bounce (BAB)—and genuine components—partial price adjustment (PPA) and time-varying risk premia (TVRP),using four key ideas: theoretically signing or bounding the components; computing returns over disjoint subperiods separated by a trade to eliminate NT and greatly reduce BAB; dividing the data period into disjoint subperiods to obtain independent measures of autocorrelation; and computing the portion of the autocorrelation that can be unambiguously attributed to PPA. We analyze daily individual and portfolio return autocorrelations in ten years’ NYSE transaction data and find compelling evidence that the PPA is a major source of the autocorrelation.

International Monetary Policy Surprise Spillovers

Wed, 5 Dec 2007 00:00:00 +0000

On April 18, 2001 US Federal Reserve Open Market Committee (FOMC) surprised financial markets by lowering the Federal Funds Target rate 1/2% between regularly scheduled FOMC meeing dates. Securities markets in the US and Australia responded. The US 30-Euro$ rate fell by 1/2%.and US and Australian five year bond yields fell by about 13 basis points. Equity returnsincreased by 3% in the US and 11/2% in Australia. This paper is the first to examine international monetary policy surprise spillovers and to estimate the response of security prices to unobservable monetary and nonmonetary surprises. Our estimates of the impact of domestic monetary policy surprises on domestic yields and returns are similar to other studies. The following results are new. US monetary policy surprises spill over and affect Australian yields and equity returns. Australian monetary surprises do not spill over to the US. Nonmonetary surprises are more important in explaining the movements in longer maturity...

Connections Between Singular Control and Optimal Switching

Wed, 5 Dec 2007 00:00:00 +0000

This paper builds a new theoretical connection between singular control of finite variation and optimal switching problems. This correspondence provides a novel method for solving high-dimensional singular control problems, and enables us to extend the theory of reversible investment: sufficient conditions are derived for the existence of optimal controls and for the regularity of value functions. Consequently, our regularity result links singular controls and Dynkin games through sequential optimal stopping problems.

Equilibrium in Continuous-Time Financial Markets: Endogenously Dynamically Complete Markets

Wed, 5 Dec 2007 00:00:00 +0000

We prove existence of equilibrium in a continuous-time securities market in which the securities are potentially dynamically complete: the number of securities is at least one more than the number of independent sources of uncertainty. We prove that dynamic completeness of the candidate equilibrium price process follows from mild exogenous assumptions on the economic primitives of the model. Our result is universal, rather than generic: dynamic completeness of the candidate equilibrium price process and existence of equilibrium follow from the way information is revealed in a Brownian filtration, and of a mild exogenous nondegeneracy condition on the terminal security dividends. The nondegeneracy condition, which requires that finding one point at which a determinant of a Jacobian matrix of dividends is nonzero, is very easy to check. We find that the equilibrium prices, consumptions, and trading strategies are well-behaved functions of the stochastic process describing the...