Professional Articles

Many Universities offer professional analysis of all sorts of subject matter. Below are those  that I believe are of merit. I do not always agree with them- but one has to address what is coming out at the college level. 


2009

4/29: "Risk Shifting and Mutual Fund Performance" Fee Download

Mutual funds change their risk levels significantly over time. This paper investigates the performance consequences of risk shifting, as well as the economic motivations and the mechanisms of risk shifting. Using a holdings-based measure of risk shifting, we find that funds that increase risk perform worse than funds that keep stable risk levels over time. In addition, funds that expect higher benefits from risk shifting are more likely to increase risk and perform particularly poorly after increasing risk. Our results are consistent with the notion that agency problems, rather than the ability to take advantage of changing investment opportunities, are the likely motivation behind risk shifting behavior.

4/29:  "Gender Differences in Risk Behaviour: Does Nurture Matter?" Fee Download

Women and men may differ in their propensity to choose a risky outcome because of innate preferences or because pressure to conform to gender-stereotypes encourages girls and boys to modify their innate preferences. Single-sex environments are likely to modify students' risk-taking preferences in economically important ways. To test this, we designed a controlled experiment in which subjects were given an opportunity to choose a risky outcome - a real-stakes gamble with a higher expected monetary value than the alternative outcome with a certain payoff - and in which the sensitivity of observed risk choices to environmental factors could be explored. The results of our real-stakes gamble show that gender differences in preferences for risk-taking are indeed sensitive to whether the girl attends a single-sex or coed school. Girls from single-sex schools are as likely to choose the real-stakes gamble as much as boys from either coed or single sex schools, and more likely than coed girls. Moreover, gender differences in preferences for risk-taking are sensitive to the gender mix of the experimental group, with girls being more likely to choose risky outcomes when assigned to all-girl groups. This suggests that observed gender differences in behaviour under uncertainty found in previous studies might reflect social learning rather than inherent gender traits.

:"Have You Heard the News? How Real-Life Expectations React to Publicity" Free Download

As evidence is accumulating that subjective expectations influence behavior and that these expectations are sometimes biased, it becomes policy-relevant to know how to influence individuals' expectations. Information in the media is likely to affect how people picture the future. This paper studies the role of public information dissemination, or publicity, in a real-life expectations formation process. For this purpose, an exceptional Dutch dataset on monthly expectations regarding the future eligibility age for old age social security is analyzed. On average, the publicity reaction in eligibility age expectations is small but the differences among subgroups are considerable. I find that higher educated and high income groups hardly adapt their expectations to relevant publicity. On the contrary, those who do not often read a newspaper have a relatively high publicity reaction. A potential explanation for this latter finding is that these groups have low quality initial expectations. If this is true, publicity thus particularly benefits the initially worse informed groups.


4/30: Why Stock-price Volatility Should Never Be a Surprise, Even in the Long Run
Equities are subject to much wider price swings than previously understood, according to a recent paper co-authored by Wharton finance and economics professor Robert Stambaugh. The research adds a new perspective to the work of Wharton finance professor Jeremy J. Siegel, author of the book Stocks for the Long Run, which says stock returns more than offset risks if you stay with the market through its ups and downs. In a recent interview with Knowledge@Wharton, the professors described their views about the market's long-term behavior.
http://knowledge.wharton.upenn.edu/article/2229.cfm

A Behavioural Perspective on Keynesian Decision Theory
By: Martin Jones (University of Dundee)
URL: http://d.repec.org/n?u=RePEc:sti:wpaper:031/2009&r=cbe
Keynes's theory of probability has been studied intensively in the past few years with much discussion of its relevance to modern economics. This paper examines Keynes's ideas in light of criticisms made by other authors and comes to the conclusion that Keynes's views on rationality are critically flawed. However, it is asserted that this actually allows more freedom for investigation when it is combined with insights from behavioural economics and gives examples where this could be fruitful. One of the side-effects of this is that there is a narrowing of the gap between Keynesian and mainstream behavioural views on decision-making.

  1. Date: 2008-02
    By: Antonio Guarino (University College London)
    Marco Cipriani (George Washington University)
    URL: http://d.repec.org/n?u=RePEc:wef:wpaper:0047&r=cbe
    We study herd behavior in a laboratory fnancial market with financial market professionals. An important novelty of the experi- mental design is the use of a strategy-like method. This allows us to detect herd behavior directly by observing subjects?decisions for all realizations of their private signal. In the paper, we compare two treatments - one in which the price adjusts to the order ?ow in such a way that herding should never occur, and one in which the presence of event uncertainty makes herding possible. In the first treatment, traders herd seldom, in accordance with both the theory and previous experimental evidence on student subjects. A proportion of traders, however, engage in contrarianism, something not accounted for by the theory. In the second treatment, on the one hand, the proportion of herding decisions increases, but not as much as the theory would suggest; on the other hand, contrarianism disappears altogether. In both treatments, in contrast with what theory predicts, subjects sometimes prefer to abstain from trading, which affects the process of price discovery negatively.
  2. Date: 2009-04
    By: Thomas Lux
    URL: http://d.repec.org/n?u=RePEc:kie:kieliw:1514&r=cbe
    We use weekly survey data on short-term and medium-term sentiment of German investors to estimate the parameters of a stochastic model of opinion dynamics. The bivariate nature of our data set also allows us to explore the interaction between the two hypothesized opinion formation processes, while consideration of the simultaneous weekly changes of the stock index DAX enables us to study the influence of sentiment on returns within a behavioral model of boundedly rational traders. Technically, we extend the maximum likelihood framework for parameter estimation in agent-based models introduced by Lux (2009a) by generalizing it to bivariate and trivariate settings. As it turns out, short-term sentiment is governed by strong social interaction with abrupt changes of direction while medium-term sentiment is a slowly moving process with more moderate social interaction. The trivariate model can potentially predict stock returns out-of-sample on the base of medium-run sentiment at least if an apparently spurious influence from short-run sentiment is discarded
    Keywords: Opinion formation, social interaction, investor sentiment

5/18:

  1. Date: 2008-02
    By: Antonio Guarino (University College London)
    Marco Cipriani (George Washington University)
    URL: http://d.repec.org/n?u=RePEc:wef:wpaper:0047&r=cbe
    We study herd behavior in a laboratory fnancial market with financial market professionals. An important novelty of the experi- mental design is the use of a strategy-like method. This allows us to detect herd behavior directly by observing subjects?decisions for all realizations of their private signal. In the paper, we compare two treatments - one in which the price adjusts to the order ?ow in such a way that herding should never occur, and one in which the presence of event uncertainty makes herding possible. In the first treatment, traders herd seldom, in accordance with both the theory and previous experimental evidence on student subjects. A proportion of traders, however, engage in contrarianism, something not accounted for by the theory. In the second treatment, on the one hand, the proportion of herding decisions increases, but not as much as the theory would suggest; on the other hand, contrarianism disappears altogether. In both treatments, in contrast with what theory predicts, subjects sometimes prefer to abstain from trading, which affects the process of price discovery negatively.
  2. Date: 2009-04
    By: Thomas Lux
    URL: http://d.repec.org/n?u=RePEc:kie:kieliw:1514&r=cbe
    We use weekly survey data on short-term and medium-term sentiment of German investors to estimate the parameters of a stochastic model of opinion dynamics. The bivariate nature of our data set also allows us to explore the interaction between the two hypothesized opinion formation processes, while consideration of the simultaneous weekly changes of the stock index DAX enables us to study the influence of sentiment on returns within a behavioral model of boundedly rational traders. Technically, we extend the maximum likelihood framework for parameter estimation in agent-based models introduced by Lux (2009a) by generalizing it to bivariate and trivariate settings. As it turns out, short-term sentiment is governed by strong social interaction with abrupt changes of direction while medium-term sentiment is a slowly moving process with more moderate social interaction. The trivariate model can potentially predict stock returns out-of-sample on the base of medium-run sentiment at least if an apparently spurious influence from short-run sentiment is discarded
    Keywords: Opinion formation, social interaction, investor sentiment

5/5:

A Behavioural Perspective on Keynesian Decision Theory
By: Martin Jones (University of Dundee)
URL: http://d.repec.org/n?u=RePEc:sti:wpaper:031/2009&r=cbe
Keynes's theory of probability has been studied intensively in the past few years with much discussion of its relevance to modern economics. This paper examines Keynes's ideas in light of criticisms made by other authors and comes to the conclusion that Keynes's views on rationality are critically flawed. However, it is asserted that this actually allows more freedom for investigation when it is combined with insights from behavioural economics and gives examples where this could be fruitful. One of the side-effects of this is that there is a narrowing of the gap between Keynesian and mainstream behavioural views on decision-making.

5/3:"Have You Heard the News? How Real-Life Expectations React to Publicity" Free Download

As evidence is accumulating that subjective expectations influence behavior and that these expectations are sometimes biased, it becomes policy-relevant to know how to influence individuals' expectations. Information in the media is likely to affect how people picture the future. This paper studies the role of public information dissemination, or publicity, in a real-life expectations formation process. For this purpose, an exceptional Dutch dataset on monthly expectations regarding the future eligibility age for old age social security is analyzed. On average, the publicity reaction in eligibility age expectations is small but the differences among subgroups are considerable. I find that higher educated and high income groups hardly adapt their expectations to relevant publicity. On the contrary, those who do not often read a newspaper have a relatively high publicity reaction. A potential explanation for this latter finding is that these groups have low quality initial expectations. If this is true, publicity thus particularly benefits the initially worse informed groups.

5/3:
The Securities and Exchange Commission has shut down two Beverly Hills hedge funds that allegedly used a web of lies to raise $38 million from 20 investors.
$38 million from just 20- amazing. But also shows how stupid some people can be.

4/29: "Risk Shifting and Mutual Fund Performance" Fee Download

Mutual funds change their risk levels significantly over time. This paper investigates the performance consequences of risk shifting, as well as the economic motivations and the mechanisms of risk shifting. Using a holdings-based measure of risk shifting, we find that funds that increase risk perform worse than funds that keep stable risk levels over time. In addition, funds that expect higher benefits from risk shifting are more likely to increase risk and perform particularly poorly after increasing risk. Our results are consistent with the notion that agency problems, rather than the ability to take advantage of changing investment opportunities, are the likely motivation behind risk shifting behavior.

4/29:  "Gender Differences in Risk Behaviour: Does Nurture Matter?" Fee Download


Women and men may differ in their propensity to choose a risky outcome because of innate preferences or because pressure to conform to gender-stereotypes encourages girls and boys to modify their innate preferences. Single-sex environments are likely to modify students' risk-taking preferences in economically important ways. To test this, we designed a controlled experiment in which subjects were given an opportunity to choose a risky outcome - a real-stakes gamble with a higher expected monetary value than the alternative outcome with a certain payoff - and in which the sensitivity of observed risk choices to environmental factors could be explored. The results of our real-stakes gamble show that gender differences in preferences for risk-taking are indeed sensitive to whether the girl attends a single-sex or coed school. Girls from single-sex schools are as likely to choose the real-stakes gamble as much as boys from either coed or single sex schools, and more likely than coed girls. Moreover, gender differences in preferences for risk-taking are sensitive to the gender mix of the experimental group, with girls being more likely to choose risky outcomes when assigned to all-girl groups. This suggests that observed gender differences in behaviour under uncertainty found in previous studies might reflect social learning rather than inherent gender traits.


4/27: The beta parameter as a measure of an asset’s risk plays a central role in finance. Estimated betas and their  predictions are used in asset pricing, cash flow valuation, risk management, making investment decisions or simply as a risk factor in models with more than one factor. Because of their central role in portfolio theory, betas have been the object of enormous research interest. The traditional setting is one where beta risk is assumed to be constant. In this framework, betas can be estimated as the slope coefficient in a simple regression model fitted by ordinary least squares. However, empirical evidence in numerous studies suggest that betas are not constant over time.

:Risk measures and their applications in asset management

Date:

2008-08-21

By:

Birbil, S.I.
Frenk, J.B.G.
Kaynar, B.
Noyan, N. (Erasmus Econometric Institute)

URL:

http://d.repec.org/n?u=RePEc:dgr:eureir:1765013050&r=rmg

Several approaches exist to model decision making under risk, where risk can be broadly defined as the effect of variability of random outcomes. One of the main approaches in the practice of decision making under risk uses mean-risk models; one such well-known is the classical Markowitz model, where variance is used as risk measure. Along this line, we consider a portfolio selection problem, where the asset returns have an elliptical distribution. We mainly focus on portfolio optimization models constructing portfolios with minimal risk, provided that a prescribed expected return level is attained. In particular, we model the risk by using Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR). After reviewing the main properties of VaR and CVaR, we present short proofs to some of the well-known results. Finally, we describe a computationally efficient solution algorithm and present numerical results.

3

4/30: Why Stock-price Volatility Should Never Be a Surprise, Even in the Long Run
Equities are subject to much wider price swings than previously understood, according to a recent paper co-authored by Wharton finance and economics professor Robert Stambaugh. The research adds a new perspective to the work of Wharton finance professor Jeremy J. Siegel, author of the book Stocks for the Long Run, which says stock returns more than offset risks if you stay with the market through its ups and downs. In a recent interview with Knowledge@Wharton, the professors described their views about the market's long-term behavior.
http://knowledge.wharton.upenn.edu/article/2229.cfm

4/20

Risk Shifting and Mutual Fund Performance
Date: 2009-04
By: Jennifer Huang
Clemens Sialm
Hanjiang Zhang
URL: http://d.repec.org/n?u=RePEc:nbr:nberwo:14903&r=rmg
Mutual funds change their risk levels significantly over time. This paper investigates the performance consequences of risk shifting, as well as the economic motivations and the mechanisms of risk shifting. Using a holdings-based measure of risk shifting, we find that funds that increase risk perform worse than funds that keep stable risk levels over time. In addition, funds that expect higher benefits from risk shifting are more likely to increase risk and perform particularly poorly after increasing risk. Our results are consistent with the notion that agency problems, rather than the ability to take advantage of changing investment opportunities, are the likely motivation behind risk shifting behavior.

4/15:  How Do Emotions Influence Saving Behavior?

Print
by Gergana Y. Nenkov, Deborah J. MacInnis, and Maureen Morrin

IB#9-8

Introduction

Employers have moved away from traditional defined benefit pension plans to defined contribution plans such as 401(k)s.  As a result, many individuals are now required to make their own retirement saving and investment decisions, which has raised concerns about their ability and desire to handle these decisions.  Since investment choices have major implications for future financial welfare, it is important to understand how individuals make these decisions and to identify potential ways to improve the decision-making process.

Researchers have explored various factors affecting retirement saving, such as income, age, job tenure, self-control failure, financial literacy and trust.  No prior research, however, has looked at the effects of emotions on retirement savings.  This Issue in Brief examines how two different emotions – hope and hopefulness – affect 401(k) participation and asset allocation.  The first section defines the terms.  The second section describes the structure of a recent field experiment.  The third section summarizes the results, which reveal that having high hope (i.e. yearning) – for a secure retirement leads to different investment behaviors than having high hopefulness (i.e. perceived likelihood).  Furthermore, threats to hope and threats to hopefulness are found to have different effects on 401(k) participation and investment decisions. 

4/15:  How does simplified disclosure affect individuals' mutual fund choices?

Date: 2009-04
By: John Beshears
James J. Choi
David Laibson
Brigitte C. Madrian
URL: http://d.repec.org/n?u=RePEc:nbr:nberwo:14859&r=cbe
We use an experiment to estimate the effect of the SEC’s Summary Prospectus, which simplifies mutual fund disclosure. Our subjects chose an equity portfolio and a bond portfolio. Subjects received either statutory prospectuses or Summary Prospectuses. We find no evidence that the Summary Prospectus affects portfolio choices. Our experiment sheds new light on the scope of investor confusion about sales loads. Even with a one-month investment horizon, subjects do not avoid loads. Subjects are either confused about loads, overlook them, or believe their chosen portfolio has an annualized log return that is 24 percentage points higher than the load-minimizing portfolio.

Juat reading teh abstract and you have an excellent idea why so much money was lost. Some journalists say that investors already know what risk is- JOKE! This is a sad commentary overall about not just the issue of reading a mutual fund prospectus but about literacy overall. 

4/14:

Financial Regulation and Risk Management: Addressing Risk Challenges in a Changing Financial Environment
Date: 2009-04-06
By: Ojo, Marianne
URL: http://d.repec.org/n?u=RePEc:pra:mprapa:14503&r=rmg
Amongst other things, this paper aims to address complexities and challenges faced by regulators in identifying and assessing risk, problems arising from different perceptions of risk, and solutions aimed at countering problems of risk regulation. It will approach these issues through an assessment of explanations put forward to justify the growing importance of risks, well known risk theories such as cultural theory, risk society theory and governmentality theory. In addressing the problems posed as a result of the difficulty in quantifying risks, it will consider a means whereby risks can be quantified reasonably without the consequential effects which result from the dual nature of risk that is, risks emanating from the management of institutional risks. Current attempts by the European Union to regulate risks will also be discussed. This discussion will be facilitated through a consideration of recent developments in the EU which are aimed at addressing risks posed by hedge funds. The results obtained from a consultation process on hedge funds, and which will be discussed in the concluding section of this paper, reveal whether the systemic relevance of hedge funds and prime brokerage regulation need to be reviewed. Questions also addressed during the consultation process, which include whether indirect prudential regulation is inadequate to shield the financial system from hedge funds’ failure and whether prudential authorities have necessary tools to monitor exposures of the core financial system to hedge funds, will also be discussed.

4/8:

IMF To Warn On Spiraling Toxic Debt: Report

TOKYO (Reuters) - Toxic debts racked up by banks and insurers could spiral to $4 trillion, new forecasts from the International Monetary Fund are set to suggest, British daily The Times reported on its website without citing sources.

The IMF said in January that it expected the deterioration in U.S.-originated assets to reach $2.2 trillion by the end of next year.

But it is understood to be looking at raising that to $3.1 trillion in its next assessment of the global economy, due to be published on April 21, the newspaper reported.

In addition, it is likely to boost that total by $900 billion for toxic assets originated in Europe and Asia,

4/7: Chronicle of Higher Education - The universities engaged in the most ambitious fund-raising campaigns have seen collections drop 32 percent over the past year as economic volatility prompts donors to postpone or rethink gifts.  The dozen universities conducting billion-dollar campaigns raised $2.71-billion from February 2008 through January 2009, compared with nearly $4-billion for the previous 12 months. Cornell University suffered the biggest drop, with donations falling 55 percent.

4/7:  Spreading Academic Pay over Nine or Twelve Months: Economists Are Supposed to Know Better, but Do They Act Better?

Date:

2009

By:

Claar, Victor V
Diestl, Christine M
Poll, Ross D

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:14273&r=cbe

Our paper empirically considers two general hypotheses related to the literature of behavioral economics. First, we test the null hypothesis that individuals behave, on average, in a manner more consistent with the rational expectations hypothesis than with the idea of self-control in the face of hyperbolic discounting in their saving decisions. Second, along a variety of dimensions, we examine whether individuals exhibit Herbert Simon’s notion that the goal formation of individuals will differ depending upon their relative levels of experience and knowledge. Perhaps there are significant differences among groups in their saving decisions that depend upon their apparent levels of intelligence, education, and knowledge. Finally, using a variety of individual-specific control variables, we test for robustness of the results.

Keywords:

Consumer Economics; Empirical Analysis; Life Cycle Models and Saving

3/16:

Institutional Trades and Herd Behavior in Financial Markets

Date:

2009-02-15

By:

Maria Grazia Romano (University of Salerno and CSEF)

URL:

http://d.repec.org/n?u=RePEc:sef:csefwp:215&r=fmk

The article studies the impact of transaction costs on the trading strategy of informed institutional investors in a sequential trading market where traders can choose to transact a large or a small amount of the stock. The analysis shows that high transaction costs may induce informed investors to herd. Moreover, for low levels of transaction costs, informed investors trade both the large and the small quantity of the asset. Finally, if transaction costs are very low and the market width is large enough, informed traders prefer to separate from small liquidity traders.

3/

3/11:  "Securitization, Transparency and Liquidity" Fee Download

MARCO PAGANO, University of Naples Federico II - Department of Economics, Centre for Economic Policy Research (CEPR), European Corporate Governance Institute (ECGI)

Email: mrpagano@tin.it
PAOLO F. VOLPIN,
London Business School, Centre for Economic Policy Research (CEPR), European Corporate Governance Institute (ECGI)
Email: pvolpin@london.edu

We present a model in which issuers of structured bonds choose coarse and opaque ratings to enhance the liquidity of their primary market, at the cost of reducing secondary market liquidity or even causing it to freeze. The degree of transparency is inefficiently low if the social value of secondary market liquidity exceeds its private value. We analyze various types of public intervention - requiring transparency for rating agencies, providing liquidity to distressed banks or supporting secondary market prices - and find that their welfare implications are quite different. Finally, transparency is greater if issuers restrain the issue size, or tranche it so as to sell the more information-sensitive tranche to sophisticated investors only.

3

3/10:

Past success and present overconfidence

Date:

2009-03

By:

Novarese, Marco

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:13754&r=cbe

According to a wide literature persons are not able to evaluate their own skills and knowledge, but the discussion on the nature, extension and determinants of this phenomenon is still open. This paper aims at proposing new empirical evidence on overconfidence and its determinants, trying to find out the possible effect of past performance on present optimism. I test my students' calibration and confidence in predicting their future results, comparing their expectations and real grades. My analysis allows showing the existence of overconfidence, its reduction in two following tests, and its non linear relation with students' capacities. Besides, I focus my attention on the effect of the grade my students got at the end of high school. This is used a proxy of their past experience and habit to get good or bad grades. Past success determined overconfidence. This idea is connected to the literature on heuristics and rule based perception.

3/3

  1. Stock-Market Crashes and Depressions

Date:

2009-02

By:

Robert J. Barro
Jose Ursua

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14760&r=fmk

Long-term data for 25 countries up to 2006 reveal 195 stock-market crashes (multi-year real returns of -25% or less) and 84 depressions (multi-year macroeconomic declines of 10% or more), with 58 of the cases matched by timing. The United States has two of the matched events - the Great Depression 1929-33 and the post-WWI years 1917-21, likely driven by the Great Influenza Epidemic. 45% of the matched cases are associated with war, and the two world wars are prominent. Conditional on a stock-market crash, the probability of a minor depression (macroeconomic decline of at least 10%) is 30% and of a major depression (at least 25%) is 11%. In a non-war environment, these probabilities are lower but still substantial - 20% for a minor depression and 3% for a major depression. Thus, the stock-market crashes of 2008-09 in the United States and other countries provide ample reason for concern about depression. In reverse, the probability of a stock-market crash is 69%, conditional on a depression of 10% or more, and 91% for 25% or more. Thus, the largest depressions are particularly likely to be accompanied by stock-market crashes, and this finding applies equally to non-war and war events. We allow for flexible timing between stock-market crashes and depressions for the 58 matched cases to compute the covariance between stock returns and an asset-pricing factor, which depends on the proportionate decline of consumption during a depression. If we assume a coefficient of relative risk aversion around 3.5, this covariance is large enough to account in a familiar looking asset-pricing formula for the observed average (levered) equity premium of 7% per year. This finding complements previous analyses that were based on the probability and size distribution of macroeconomic disasters but did not consider explicitly the covariance between macroeconomic declines and stock returns.

JEL:

E01 E21 E23 E44 G12

  1. The Future of Securities Regulation

Date:

2009-01

By:

Zingales, Luigi

URL:

http://d.repec.org/n?u=RePEc:cpr:ceprdp:7110&r=fmk

The U.S. system of security law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone. For this reason, I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management.

Keywords:

coorporate goverance; security regulation

JEL:

G18 G38 K22

  1. Learning in Financial Markets

Date:

2009-01

By:

Pástor, Luboš
Veronesi, Pietro

URL:

http://d.repec.org/n?u=RePEc:cpr:ceprdp:7127&r=fmk

We survey the recent literature on learning in financial markets. Our main theme is that many financial market phenomena that appear puzzling at first sight are easier to understand once we recognize that parameters in financial models are uncertain and subject to learning. We discuss phenomena related to the volatility and predictability of asset returns, stock price bubbles, portfolio choice, mutual fund flows, trading volume, and firm profitability, among others.

3/3:Why do risk premia vary over time? A theoretical investigation under habit formation

Date:

2009-02-16

By:

De Paoli, Bianca (Bank of England)
Zabczyk, Pawel (Bank of England)

URL:

http://d.repec.org/n?u=RePEc:boe:boeewp:0361&r=fmk

Empirical evidence suggests that risk premia are higher at business cycle troughs than they are at peaks. Existing asset pricing theories ascribe moves in risk premia to changes in volatility or risk aversion. Nevertheless, in a simple general equilibrium model, risk premia can be procyclical even though the volatility of consumption is constant and despite a countercyclically varying risk aversion coefficient. We show that agents' expectations about future prospects also influence premium dynamics. In order to generate countercyclically varying premia, as found in the data, one requires a combination of hump-shaped consumption dynamics or highly persistent shocks and habits. Our results, thus, suggest that factors which help match activity data may also help along the asset pricing dimension.

3/3:  Stock-Market Crashes and Depressions

Date:

2009-02

By:

Robert J. Barro
Jose Ursua

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14760&r=rmg

Long-term data for 25 countries up to 2006 reveal 195 stock-market crashes (multi-year real returns of -25% or less) and 84 depressions (multi-year macroeconomic declines of 10% or more), with 58 of the cases matched by timing. The United States has two of the matched events - the Great Depression 1929-33 and the post-WWI years 1917-21, likely driven by the Great Influenza Epidemic. 45% of the matched cases are associated with war, and the two world wars are prominent. Conditional on a stock-market crash, the probability of a minor depression (macroeconomic decline of at least 10%) is 30% and of a major depression (at least 25%) is 11%. In a non-war environment, these probabilities are lower but still substantial - 20% for a minor depression and 3% for a major depression. Thus, the stock-market crashes of 2008-09 in the United States and other countries provide ample reason for concern about depression. In reverse, the probability of a stock-market crash is 69%, conditional on a depression of 10% or more, and 91% for 25% or more. Thus, the largest depressions are particularly likely to be accompanied by stock-market crashes, and this finding applies equally to non-war and war events. We allow for flexible timing between stock-market crashes and depressions for the 58 matched cases to compute the covariance between stock returns and an asset-pricing factor, which depends on the proportionate decline of consumption during a depression. If we assume a coefficient of relative risk aversion around 3.5, this covariance is large enough to account in a familiar looking asset-pricing formula for the observed average (levered) equity premium of 7% per year. This finding complements previous analyses that were based on the probability and size distribution of macroeconomic disasters but did not consider explicitly the covariance between macroeconomic declines and stock returns.

3/2:  Sorting out Downside Beta

Date:

2009-02-18

By:

Post, G.T.
Vliet, P. van
Lansdorp, S.D. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)

URL:

http://d.repec.org/n?u=RePEc:dgr:eureri:1765014843&r=rmg

Downside risk, when properly defined and estimated, helps to explain the cross-section of US stock returns. Sorting stocks by a proper estimate of downside market beta leads to a substantially larger cross-sectional spread in average returns than sorting on regular market beta. This result arises despite the fact that downside beta is based on fewer return observations and therefore is more difficult to estimate and predict. The explanatory power of downside risk remains after controlling for other stock characteristics, including firm-level size, value and momentum.

3/

3/2:  Cognitive Dissonance as a Means of Reducing Hypothetical Bias

Date:

2009-02-23

By:

Alfnes, Frode
Yue, Chengyan
Jensen, Helen H.

URL:

http://d.repec.org/n?u=RePEc:isu:genres:13033&r=cbe

Hypothetical bias is a persistent problem in stated preference studies. We propose and test a method for reducing hypothetical bias based on the cognitive dissonance literature in social psychology. A central element of this literature is that people prefer not to take inconsistent stands and will change their attitudes and behavior to make them consistent. We find that participants in a stated preference willingness-to-pay study, when told that a nonhypothetical study of similar goods would follow, state significantly lower willingness to pay than participants not so informed. In other words, participants adjust their stated willingness to pay to avoid cognitive dissonance from taking inconsistent stands on their willingness to pay for the good being offered.

3/1: "The Adequacy of Economic Resources in Retirement" Free Download

Michigan Retirement Research Center Research Paper No. 2008-184

MICHAEL D. HURD, The RAND Corporation, SUNY at Stony Brook University, College of Arts and Science, Department of Economics, National Bureau of Economic Research (NBER)
Email: mhurd@RAND.ORG
SUSANN ROHWEDDER,
The RAND Corporation
Email: Susannr@rand.org

The most common metric for assessing the adequacy of economic preparation for retirement is the income replacement rate, the ratio of income after retirement to income before retirement. However both economic theory and common sense say that someone is adequately prepared if she is able to maintain her level of economic well-being, which is not the same as maintaining her level of income or some fixed proportion of income. Economic well-being is typically measured by consumption, which is the measure we use. We define and estimate measures of economic preparation for retirement based on a complete inventory of economic resources, particularly wealth, which we compare with optimal consumption paths. We find that a substantial majority of those just past the usual retirement age are adequately prepared for retirement in that they will be able to finance a path of consumption that begins at their current level of consumption and then follows an age-pattern similar to that of current retirees. This is not true, however, for all groups in the population. In particular, almost half of singles who lack a high school education are likely to be forced to reduce consumption. Couples are much better prepared than singles. But because of taxes a substantial number of married college graduates will have to reduce consumption.

3/1: "Retirement Wealth Across Cohorts: The Role of Earnings Inequality and Pension Changes" Free Download


Michigan Retirement Research Center Research Paper No. 2008-186

ANN HUFF STEVENS, University of California, Davis - Department of Economics, National Bureau of Economic Research (NBER)
Email: annstevens@ucdavis.edu

Changes in labor markets over the past 30 years suggest upcoming changes in the distribution of wealth at retirement. Baby boom cohorts have spent the majority of their prime earnings years in a labor market with increased earnings inequality. This paper investigates how changes in lifetime earnings distributions affect the distribution of retirement wealth among cohorts retiring over the next decade. I use data from the Health and Retirement Study from 1992 to 2004 to estimate the relationship between lifetime earnings, pre-retirement private wealth and Social Security wealth. I show that changes in the lower half of the male earnings distribution explain a substantial portion of changes in the distribution of pre-retirement wealth. Growth in women's earnings across the cohorts do not offset these declines in wealth associated with male earnings. When pensions are added to the measure of wealth, the role of earnings is even larger, reflecting a strong correlation between changes in earnings across these cohorts and changes in the values of their employer-provided pensions. These pension changes do not appear to operate via changes in pension structures (defined benefit versus defined contribution). The present value of wealth from future Social Security benefits, in contrast, grows in real terms throughout most of the distribution. At the bottom of the male distribution of Social Security wealth, reductions in lifetime earnings limit this growth in real benefits, while at the top of the distribution earnings growth amplifies expected growth in Social Security wealth.

3/1: Are Stocks Really Less Volatile in the Long Run?" Fee Download

Conventional wisdom views stocks as less volatile over long horizons than over short horizons due to mean reversion induced by return predictability. In contrast, we find stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. We decompose return variance into five components, which include mean reversion and various uncertainties faced by the investor. Although mean reversion makes a strong negative contribution to long-horizon variance, it is more than offset by the other components. Using a predictive system, we estimate annualized 30-year variance to be nearly 1.5 times the 1-year variance.

We find that stocks are actually more volatile over long horizons. At a 30-year horizon, for
example, we find return variance per year to be 21 to 53 percent higher than the variance at a
1-year horizon. This conclusion stems from the fact that we assess variance from the perspective
of investors who condition on available information but realize their knowledge is limited in two
key respects. First, even after observing 206 years of data (1802–2007), investors do not know the
values of the parameters that govern the processes generating returns and observable “predictors”
used to forecast returns. Second, investors recognize that, even if those parameter values were
known, the predictors could deliver only an imperfect proxy for the conditional expected return.

Of the four components contributing positively, the one making the largest contribution at
the 30-year horizon reflects uncertainty about future expected returns. This component (iii) is
often neglected in discussions of how return predictability affects long-horizon return variance.
Such discussions typically highlight mean reversion, but mean reversion—and predictability more
generally—require variance in the conditional expected return, which we denote by t . That
variance makes the future values of t uncertain, especially in the more distant future periods,
thereby contributing to the overall uncertainty about future returns. The greater the degree of
predictability, the larger is the variance of t and thus the greater is the relative contribution of
uncertainty about future expected returns to long-horizon return variance.

We split the 1802–2007 sample in half and estimate the
predictive variances separately at the ends of both subperiods. In the first subperiod, the predictive
variance per period rises monotonically with the horizon, under the benchmark priors. In the
second subperiod, the predictive variance exhibits a U-shape with respect to the horizon: it initially
decreases, reaching its minimum at the horizon of 7 years, but it increases afterwards, rising above
the 1-year variance at the horizon of 18 years. That is, the negative effect of mean reversion
prevails at short horizons, but the combined positive effects of estimation risk and uncertainty
about current and future t ’s prevail at long horizons. For both subperiods, the 30-year predictive
variance exceeds the 1-year variance across all prior specifications.

We find that stock volatility is greater at long horizons than at short horizons, thereby making
stocks less appealing to long-horizon investors than conventional wisdom would suggest. This
finding does not necessarily imply that long-horizon investors should hold less stock than short horizon
investors. Stock volatility is only one key ingredient in a problem that no doubt involves
other considerations of first-order importance, such as human capital and bond volatility, that are
beyond the scope of this study.19 Investigating asset-allocation decisions while allowing the higher
long-run stock volatility to enter the problem offers an interesting direction for future research.

2/26:  "Financial Literacy and Planning: Implications for Retirement Wellbeing" Free Download


Michigan Retirement Research Center Research Paper No. WP 2005-108

2/24: “An Experimental Investigation of Why Individuals Conform,” by Basit Zafar
Social interdependence is believed to play an important role in how people make individual choices. This paper presents a simple model constructed on the premise that people are motivated by their own payoff as well as by how their actions compare with those of other people in their reference group. The author shows that conformity of actions may arise either from learning about the norm (social learning), or from adhering to the norm because of image-related concerns (social influence). To disentangle the two empirically, Zafar uses the fact that image-related concerns can be present only if actions are publicly observable. The model predictions are tested in a “charitable contribution” experiment in which the actions and identities of the subjects are unmasked in a controlled and systematic way. Both social learning and social influence seem to play an important role in the subjects’ choices. In addition, individuals gain utility simply by making the same choice as the reference group (social comparison) and change their contributions in the direction of the social norm even when their identities are hidden. Once the identities and contribution distributions of group members are revealed, individuals conform to the modal choice of the group. Moreover, the author finds that social ties (defined as subjects knowing one another from outside the experimental environment) affect the role of social influence. In particular, a low-contribution norm evolves that causes individuals to contribute less in the presence of people they know.

2/24:  Experimental tests on consumption, savings and pensions

Date:

2008-12-23

By:

Enrique Fatás (LINEX, University of Valencia.)
Juan A. Lacomba (Department of Economic Theory and Economic History, University of Granada.)
Francisco M. Lagos (Department of Economic Theory and Economic History, University of Granada.)
Ana I. Moro (Department of Economic Theory and Economic History, University of Granada.)

URL:

http://d.repec.org/n?u=RePEc:gra:wpaper:08/14&r=cbe

As part of the current debate on the reform of pension systems, this article examines the potential effects on consumption behaviour of implementing a lump-sum payment in a public pension system. This work explores an experimental investigation into retirement consumption behaviour with two central features: first, there exists a decreasing probability of surviving; second, there are two sequences of income, one when individual works and another when she is retired. The results show how subjects seem to plan their consumption and saving choices conditionated by both the long horizon with no incomes and the lump-sum payment. This yields, in the majority of periods, a surprising over-saving behaviour.

2/24:  Gender Differences in Risk Aversion and Ambiguity Aversion

Date:

2009-01

By:

Borghans, Lex (Maastricht University)
Golsteyn, Bart (Maastricht University)
Heckman, James J. (University of Chicago)
Meijers, Huub (Maastricht University)

URL:

http://d.repec.org/n?u=RePEc:iza:izadps:dp3985&r=cbe

This paper demonstrates gender differences in risk aversion and ambiguity aversion. It also contributes to a growing literature relating economic preference parameters to psychological measures by asking whether variations in preference parameters among persons, and in particular across genders, can be accounted for by differences in personality traits and traits of cognition. Women are more risk averse than men. Over an initial range, women require no further compensation for the introduction of ambiguity but men do. At greater levels of ambiguity, women have the same marginal distaste for increased ambiguity as men. Psychological variables account for some of the interpersonal variation in risk aversion. They explain none of the differences in ambiguity.

Date:

2009-02-10

By:

Chollete, Lorán (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

URL:

http://d.repec.org/n?u=RePEc:hhs:nhhfms:2008_025&r=rmg

What drives extreme economic events? Motivated by recent theory, and events in US subprime markets, we begin to open the black box of extremes. Specifically, we extend standard economic analysis of extreme risk, allowing for dynamics and endogeneity. We explain how endogenous extremes may arise in an economy of individuals who engage in resource transfers. Our model suggests that susceptibility to extremes depends on differences in marginal substitution rates. Using over a century of daily stock price data, we construct empirical probabilities of extremes, and document interesting dynamic behavior. We find evidence that extremes are endogenous. This latter finding raises the possibility that control of extremes is a public good, and that extreme events may be an important market failure for regulators and central banks to correct.

2/23:

2/19: What Does the Yield Curve Tell Us About Exchange Rate Predictability?

Date:

2009

By:

Yu-chin Chen
Kwok Ping Tsang

URL:

http://d.repec.org/n?u=RePEc:vpi:wpaper:e07-15&r=fmk

This paper uses information contained in the cross-country yield curves to test the asset-pricing approach to exchange rate determination, which models the nominal exchange rate as the discounted present value of its expected future fundamentals. Research on the term structure of interest rates has long argued that the yield curve contains information about future economic activity such as GDP growth and inflation. Bringing this lesson to the international context, we extract the Nelson-Siegel (1987) factors of relative level, slope, and curvature from cross-country yield differences to proxy expected movements in future exchange rate fundamentals. Using monthly data between 1985-2005 for the United Kingdom, Canada, Japan and the US, we show that the yield curve factors indeed can explain and predict bilateral exchange rate movements and excess currency returns one month to two years ahead. Out-of- sample analysis also shows the yield curve factors to outperform a random walk in forecasting short-term exchange rate returns.

Keywords:

Exchange Rate Forecasting, Term Structure of Interest Rates, Uncovered Interest, Parity

2/16:  The first global financial crisis of the 21st century: Introduction

Date:

2008-07

By:

Reinhart, Carmen

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:13288&r=rmg

Global financial markets are showing strains on a scale and scope not witnessed in the past three-quarters of a century. What started with elevated losses on U.S.-subprime mortgages has spread beyond the borders of the United States and the confines of the mortgage market. Many risk spreads have ballooned, liquidity in some market segments has dried up, and large complex financial institutions have admitted significant losses. Bank runs are no longer the subject exclusively of history.These events have challenged policymakers, and the responses have varied across region. The European Central Bank has injected reserves in unprecedented volumes. The Bank of England participated in the bail-out and, ultimately, the nationalization of a depository, Northern Rock. The U.S. Federal Reserve has introduced a variety of new facilities and extended its support beyond the depository sector. These events have also challenged economists to explain why the crisis developed, how it is unfolding, and what can be done. This volume compiles contributions by leading economists in VoxEU over the past year that attempt to answer these questions. We have grouped these contributions into three sections corresponding to those three critical questions.

2/16:Forecasting a Large Dimensional Covariance Matrix of a Portfolio of Different Asset Classes

Date:

2009-01

By:

Lillie Lam (Research Department, Hong Kong Monetary Authority)
Laurence Fung (Research Department, Hong Kong Monetary Authority)
Ip-wing Yu (Research Department, Hong Kong Monetary Authority)

URL:

http://d.repec.org/n?u=RePEc:hkg:wpaper:0901&r=rmg

In portfolio and risk management, estimating and forecasting the volatilities and correlations of asset returns plays an important role. Recently, interest in the estimation of the covariance matrix of large dimensional portfolios has increased. Using a portfolio of 63 assets covering stocks, bonds and currencies, this paper aims to examine and compare the predictive power of different popular methods adopted by i) market practitioners (such as the sample covariance, the 250-day moving average, and the exponentially weighted moving average); ii) some sophisticated estimators recently developed in the academic literature (such as the orthogonal GARCH model and the Dynamic Conditional Correlation model); and iii) their combinations. Based on five different criteria, we show that a combined forecast of the 250-day moving average, the exponentially weighted moving average and the orthogonal GARCH model consistently outperforms the other methods in predicting the covariance matrix for both one-quarter and one-year ahead horizons.

2/16:

Effects of unobserved defaults on correlation between probability of default and loss given default on mortgage loans

Date:

2009-01-21

By:

Palmroos, Peter (Bank of Finland Research)

URL:

http://d.repec.org/n?u=RePEc:hhs:bofrdp:2009_003&r=rmg

This paper demonstrates how the observed correlation between probability of default and loss given default depends on the fact that defaults in which collateral provides 100% recovery are not observed. Creditors see only the defaults of mortgagors who suffer from a fall in collateral value to less than the remaining loan principal. Consequently, the default data available to creditors amounts to a mere truncated sample from the underlying population of defaults. Correlation estimates based on such truncated samples are biased and differ substantially from estimates derived from representative non-truncated samples. Moreover, the observed correlation between default probability and loss given default is sensitive to the truncation point, which may explain the differences in correlation estimates found in the literature. This may also explain why correlation estimates seem to be specific to cycle phase.

2/

2/10  Risk Management Failures: What Are They and When Do They Happen? READ THIS IF INTERESTED IN RISK. ONE OF THE BEST IN NON TECHNICAL JARGON

Date:

2008-10

By:

Stulz, Rene M. (Ohio State U and ECGI)

URL:

http://d.repec.org/n?u=RePEc:ecl:ohidic:2008-18&r=rmg

A large loss is not evidence of a risk management failure because a large loss can happen even if risk management is flawless. I provide a typology of risk management failures and show how various types of risk management failures occur. Because of the limitations of past data in assessing the probability and the implications of a financial crisis, I conclude that financial institutions should use scenarios for credible financial crisis threats even if they perceive the probability of such events to be extremely small.

In a typical firm, the role of risk management is first to assess the risks faced by the firm, communicate these risks to those who make risk-taking decisions for the firm, and finally manage and monitor those risks to make sure that the firm only bears the risks its management and board of directors want it to bear. In general, a firm will specify a risk measure that it focuses on together with additional risk metrics. When that risk measure exceeds the firm’s tolerance for risk, risk is reduced. Alternatively, when the risk measure is too low for the firm’s risk tolerance, the firm increases its risk. Because firms are generally more concerned about unexpected losses, a frequently used risk measure is Value-at-Risk or VaR, a measure of downside risk. VaR is the maximum loss at a given confidence level over a given period of time. Hence, if the 95% confidence level is used and a firm has a one-day VaR of $150 million, the firm has a 5% chance of making a loss in excess of $150 million over the next day if the VaR is correctly estimated. This measure might be estimated daily or over longer periods of time.

EFM- VAR is a statistical formula relied on by many firms. It uses standard numbers for risk. My point is this as defined by Mandelbrot. "The professors who live by the bell curve adopted it for mathematical convenience, not realism. It asserts that when you measure the world, the numbers that result hover around the mediocre; big departures from the mean are so rare that their effect is negligible. This focus on averages works well with everyday physical variables such as height and weight, but not when it comes to finance. One can disregard the odds of a person's being miles tall or tons heavy, but similarly excessive observations can never be ruled out in economic life. The German mark's move from four per dollar to four trillion per dollar after World War I should have taught economists to beware the bell curve.

. The economic world is driven primarily by random jumps. Yet the common tools of finance were designed for random walks in which the market always moves in baby steps. Despite increasing empirical evidence that concentration and jumps better characterize market reality, the reliance on the random walk, the bell-shaped curve, and their spawn of alphas and betas is accelerating, widening a tragic gap between reality and the standard tools of financial measurement. 

To blow up an academic dogma, empirical observations do not suffice. A better theory is needed, and one exists: the fractal theory of risk, ruin, and return. In this approach, concentration and random jumps are not belated fudges but the point of departure

In market terms, a power-law distribution implies that the likelihood of a daily or weekly drop exceeding 20% can be predicted from the frequency of drops exceeding 10%, and that the same ratio applies to a 10% vs. a 5% drop. In bell-curve finance, the chance of big drops is vanishingly small and is thus ignored. The 1987 stock market crash was, according to such models, something that could happen only once in several billion billion years. In power-law finance, big drops—while certainly less likely than small ones—remain a real and calculable possibility.

Another aspect of the real world tackled by fractal finance is that markets keep the memory of past moves, particularly of volatile days, and act according to such memory. Volatility breeds volatility; it comes in clusters and lumps. This is not an impossibly difficult or obscure framework for understanding markets. In fact, it accords better with intuition and observed reality than the bell-curve finance that still dominates the discourse of both academics and many market players.

Fractal finance, alas, has not yet earned a place in the MBA curriculum. Until that happy day, what is a person with money at stake to do? First, diversify as broadly as you can—far more than the supposed experts tell you now. This isn't just a matter of avoiding losses: Long-run market returns are dominated by a small number of investments, hence the risk of missing them must be mitigated by investing as broadly as possible. Passive indexing is far more effective than active selection—but you need to go well beyond an S&P 500 fund to do yourself much good. And wherever you put your money, understand that conventional measures of risk severely underestimate potential losses —and gains. For better or worse, your exposure is larger than you think. " 

2/9: "Real Effects of the Subprime Mortgage Crisis: Is it a Demand or a Finance Shock?" Free Download

We develop a methodology to study how the subprime crisis spills over to the real economy. Does it manifest itself primarily through reducing consumer demand or through tightening liquidity constraint on non-financial firms? Since most non-financial firms have much larger cash holding than before, they appear unlikely to face significant liquidity constraint. We propose a methodology to estimate these two channels of spillovers. We first propose an index of a firm's sensitivity to consumer demand, based on its response to the 9/11 shock in 2001. We then construct a separate firm-level index on financial constraint based on Whited and Wu (2006). We find that both channels are at work, but a tightened liquidity squeeze is economically more important than a reduced consumer spending in explaining cross firm differences in stock price declines.

1/27:  Theories of the evolution of cooperative behaviour: A critical survey plus some new results

Date:

2009-01-04

By:

Rowthorn, Robert E.
Guzmán, Ricardo Andrés
Rodríguez-Sickert, Carlos

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:12574&r=cbe

Gratuitous cooperation (in favour of non-relatives and without repeated interaction) eludes traditional evolutionary explanations. In this paper we survey the various theories of cooperative behaviour, and we describe our own effort to integrate these theories into a self-contained framework. Our main conclusions are as follows. First: altruistic punishment, conformism and gratuitous cooperation co-evolve, and group selection is a necessary ingredient for the co-evolution to take place. Second: people do not cooperate by mistake, as most theories imply; on the contrary, people knowingly sacrifice themselves for others. Third: in cooperative dilemmas conformism is an expression of preference, not a learning rule. Fourth, group-mutations (e.g., the rare emergence of a charismatic leader that brings order to the group) are necessary to sustain cooperation in the long run.

1/26:  The Aftermath of Financial Crises

Date:

2009-01

By:

Carmen M. Reinhart
Kenneth S. Rogoff

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14656&r=fmk

This paper examines the depth and duration of the slump that invariably follows severe financial crises, which tend to be protracted affairs. We find that asset market collapses are deep and prolonged. On a peak-to-trough basis, real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Not surprisingly, banking crises are associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls an average of over 9 percent, although the duration of the downturn is considerably shorter than for unemployment. The real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. The main cause of debt explosions is usually not the widely cited costs of bailing out and recapitalizing the banking system. The collapse in tax revenues in the wake of deep and prolonged economic contractions is a critical factor in explaining the large budget deficits and increases in debt that follow the crisis. Our estimates of the rise in government debt are likely to be conservative, as these do not include increases in government guarantees, which also expand briskly during these episodes.

1/26:  Stages of the 2007/2008 Global Financial Crisis: Is There a Wandering Asset-Price Bubble?

Date:

2008-12-10

By:

Orlowski, Lucjan T

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:12696&r=fmk

This study identifies five distinctive stages of the current global financial crisis: the meltdown of the subprime mortgage market; spillovers into broader credit market; the liquidity crisis epitomized by the fallout of Northern Rock, Bear Stearns and Lehman Brothers with counterparty risk effects on other financial institutions; the commodity price bubble, and the ultimate demise of investment banking in the U.S. The study argues that the severity of the crisis is influenced strongly by changeable allocations of global savings coupled with excessive credit creation, which lead to over-pricing of varied types of assets. The study calls such process a “wandering asset-price bubble”. Unstable allocations elevate market, credit and liquidity risks. Monetary policy responses aimed at stabilizing financial markets are proposed.

1/26:Learning in Financial Markets

Date:

2009-01

By:

Ľuboš Pástor
Pietro Veronesi

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14646&r=fmk

We survey the recent literature on learning in financial markets. Our main theme is that many financial market phenomena that appear puzzling at first sight are easier to understand once we recognize that parameters in financial models are uncertain and subject to learning. We discuss phenomena related to the volatility and predictability of asset returns, stock price bubbles, portfolio choice, mutual fund flows, trading volume, and firm profitability, among others.

1/20:Vision and Flexibility

Date:

2009-01

By:

Junichiro Ishida (Osaka School of International Public Policy (OSIPP),Osaka University)

URL:

http://d.repec.org/n?u=RePEc:osp:wpaper:09e001&r=cbe

An effective leader must have a clear vision and a strong will to stand by it, even in turbulent times. At the same time, though, it is also equally important to be open-minded and flexible enough to respond objectively to new information without being prejudiced by prior information. This paper illustrates how these seemingly contradictory qualifications are related and determined in a model of intrapersonal conflicts. We consider a decision maker who is capable of deceiving herself and manipulating information in some particular way to construct a rosy view of the world. There is a cost of doing so, however, because a distorted belief leads to a distorted action which is in general less efficient. This tradeoff creates a tension within herself and constrains the extent of information manipulation, thereby allowing us to identify the determinants of vision and flexibility. Among other things, we show that vision and flexibility are substitutes, and their respective levels depend crucially on attributes such as self-confidence level and fragility as well as the strength of willpower.

1/20:

1/19:  The Spread of the Credit Crisis: View from a Stock Correlation Network

Date:

2008-12-02

By:

Smith, Reginald

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:12659&r=rmg

The credit crisis roiling the world's financial markets will likely take years and entire careers to fully understand and analyze. A short empirical investigation of the current trends, however, demonstrates that the losses in certain markets, in this case the US equity markets, follow a cascade or epidemic flow like model along the correlations of various stocks. A few images and explanation here will suffice to show the phenomenon. Also, whether the idea of "epidemic" or a "cascade" is a metaphor or model for this crisis will be discussed. Animations of the spread of the crisis are available at http://reggiesmithsci.googlepages.com/creditcrisis

1/19:   C

1/13: Skill, Luck, Overconfidence, and Risk Taking

Date:

2008-12

By:

Natalia Karelaia
Robin Hogarth

URL:

http://d.repec.org/n?u=RePEc:upf:upfgen:1131&r=cbe

In most naturally occurring situations, success depends on both skill and chance. We compare experimental market entry decisions where payoffs depend on skill alone and combinations of skill and luck. We find more risk taking with skill and luck as opposed to skill alone, particularly for males, and little overconfidence. Our data support an explanation based on differential attitudes toward luck by those whose self-assessed skills are low and high. Making luck more important induces greater optimism for the former, while the latter maintain a belief that high levels of skill are sufficient to overcome the vagaries of chance.

 

1/6/09:  "Behavioral Biases and Mutual Fund Clienteles" Free Download

We predict that investors with relatively strong behavioral biases are more likely to display poor decisions and poor performance concerning mutual funds. Such investors are more likely to put a larger proportion of their wealth into individual stocks, rather than mutual funds. But when these investors do select mutual funds, they are more likely to pick the “wrong” funds, or use funds inappropriately. They will tend to select higherexpense mutual funds rather than index funds, and rebalance their mutual fund holdings more frequently than other investors. When combined with the higher fees associated with funds that target these investors, they will experience relatively poor performance.

Our evidence also indicates that, even though equity mutual funds are typically marketed as vehicles for cheap and effective diversification, they often fail to attract the small, “unsophisticated” investors for whom simple index mutual funds are particularly beneficial. Instead they attract relatively more affluent, educated, and experienced investors who are more likely to be aware of the prescriptions of basic portfolio theory Those “unsophisticated” investors who do invest in mutual funds typically select poor quality funds and experience relatively poor portfolio performance as a consequence. In light of these findings, it appears that a public campaign to increase the awareness of basic investment principles is likely to even the playing field among different types of individual investors.

2008

Confidence in Monetary Policy

Date:

2008-12

By:

Yakov Ben-Haim
Maria Demertzis

URL:

http://d.repec.org/n?u=RePEc:dnb:dnbwpp:192&r=cbe

In situations of relative calm and certainty, policy makers have confidence in the mechanisms at work and feel capable of attaining precise and ambitious results. As the environment becomes less and less certain, policy makers are confronted with the fact that there is a trade-off between the quality of a certain outcome and the confidence (robustness) with which it can be attained. Added to that, in the presence of Knightian uncertainty, confidence itself can no longer be represented in probabilistic terms (because probabilities are unknown). We adopt the technique of Info-Gap Robust Satisficing to first define confidence under Knightian uncertainty, and second quantify the trade-off between quality and robustness explicitly.We apply this to a standard monetary policy example and provide Central Banks with a framework to rank policies in a way that will allow them to pick the one that either maximizes confidence given an acceptable level of performance, or alternatively, optimizes performance for a given level of confidence

12

12/23:

  1. The Private Equity Premium Puzzle Revisited : New Evidence on the Role of Heterogeneous Risk Attitudes

Date:

2008

By:

Frank M. Fossen

URL:

http://d.repec.org/n?u=RePEc:diw:diwwpp:dp839&r=fmk

The empirical finding that entrepreneurs tend to invest a large share of their wealth in their own firms despite comparably low returns and high risk has become known as the private equity premium puzzle. This paper provides evidence supporting the hypothesis that lower risk aversion of entrepreneurs, and not necessarily credit constraints, may explain this puzzle. The analysis is based on a large, representative panel data set for Germany, which provides information on asset portfolios and experimentally validated risk attitudes. The results show that both the ownership probability and the conditional portfolio share of private business equity significantly increase with higher risk tolerance.

Keywords:

Entrepreneurship, Private Equity, Investment, Risk Aversion

JEL:

G11 G32 L26 J23 D81

  1. Mispricing of S&P 500 Index Options

Date:

2008-12

By:

George M. Constantinides
Jens Carsten Jackwerth
Stylianos Perrakis

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14544&r=fmk

Widespread violations of stochastic dominance by one-month S&P 500 index call options over 1986-2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although pre-crash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data. Substantial violations by post-crash OTM calls contradict the notion that the problem primarily lies with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the post-crash period 1988-1995 is followed by a substantial increase over 1997-2006 which may be due to the lower quality of the data but, in any case, does not provide evidence that the options market is becoming more rational over time.

12/22:  Say what???

Isolating the Systematic Component of a Single Stock’s (or Portfolio’s) Standard Deviation

Date:

2008-12

By:

Cara Marshall (Department of Economics, Queens College of the City University of New York)

URL:

http://d.repec.org/n?u=RePEc:quc:wpaper:0003&r=rmg

This paper revisits the roots of modern portfolio theory and the recognition that a stock’s (or a stock portfolio’s) risk can be decomposed into a systematic component and an unsystematic component, and, further, that only the former should contribute to expected return. However, instead of isolating the systematic component of risk by recasting the risk in terms of a stock’s beta coefficient, I choose to decompose the standard deviation, or variance if one prefers the original risk measure, directly into its systematic and unsystematic components allowing one to focus on systematic risk and yet remain in the mean/standard deviation (or mean/variance) space. When the standard deviation of return is decomposed into its systematic and unsystematic components, an “adjusted CML” can be derived and it is easily shown that this adjusted CML is equivalent to Sharpe’s SML. This alternative way of looking at systematic and unsystematic risk offers easily accessible insights into the very nature of risk. This has a number of interesting implications including, but not limited to, reducing the computational complexities in calculating the relevant portion of a portfolio’s volatility, facilitating sophisticated dispersion trades, estimating risk-adjusted returns, and improving risk-adjusted performance measurement. This paper is, in part, pedagogical and, in part, an introduction to an alternative way of measuring systematic and unsystematic risk.

12/2/ 08: Interesting

What is a Company Really Worth? Intangible Capital and the "Market to Book Value" Puzzle

Date:

2008-12

By:

Charles R. Hulten
Xiaohui Hao

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14548&r=rmg

"What is a company really worth?" is a question asked repeatedly during the recent financial crisis. Attention has been focused on short-term valuation issues, like the "mark-to-market" controversy. Sorting out these issues is complicated by the fact that the market puts a value on shareholder equity that is consistently more than twice the reported book value of a company. Numerous observers have pointed to the absence of most intangible assets from financial statements as an important source of this puzzle. We use Compustat financial data for 617 R&D intensive firms to test this possibility. We find that conventional book value alone explains only 31 percent of the market capitalization of these firms in 2006, and that this increases to 75 percent when our estimates of intangible capital are included. The debt-equity ratio also falls from 1.46 to 0.61. These findings suggest that financial reports tend to substantially understate the long-run intrinsic value of corporate America.

12/3: It's all about risk- 

Behind the 2008 Capital Market Collapse

Date:

2008-10-26

By:

C-René Dominique

URL:

http://d.repec.org/n?u=RePEc:eei:rpaper:eeri_rp_2008_17&r=cbe

Greed and the unethical behavior of financial institutions obviously played a part in the collapse of the world capital market in 2008. But, this paper argues that the main culprits are the neo-liberal ideology (requiring ever smaller gov-ernments and privatization) and the flawed theories of risk assessment. It also finds that given the fact that market economies are fractal structures, the objective assessment and / or the quantification of risks is not even possible. It concludes with some recommendations as to how to avoid future collapses.

12/3: I am 7'6"

MAKING SENSE OF THE LABOR MARKET HEIGHT PREMIUM: EVIDENCE FROM THE BRITISH HOUSEHOLD PANEL SURVEY

Date:

2008-05

By:

Anne Case (Princeton University)
Christina Paxson (Princeton University)
Mahnaz Islam (Princeton University)

URL:

http://d.repec.org/n?u=RePEc:pri:rpdevs:1072&r=cbe

We use nine waves of the British Household Panel Survey (BHPS) to investigate the large labor market height premium observed in the BHPS, where each inch of height is associated with a 1.5 percent increase in wages, for both men and women. We find that half of the premium can be explained by the association between height and educational attainment among BHPS participants. Of the remaining premium, half can be explained by taller individuals selecting into higher status occupations and industries. These effects are consistent with our earlier findings that taller individuals on average have greater cognitive function, which manifests in greater educational attainment, and better labor market opportunities.

12

11/23: "Dynamic Mean-Variance Asset Allocation" Free Download

multi-period problems, and yet not much is known about their dynamically optimal policies. We provide a fully analytical characterization of the optimal dynamic mean-variance portfolios within a general incomplete-market economy, and recover a simple structure that also inherits several conventional properties of static models. We also identify a probability measure that incorporates intertemporal hedging demands and facilitates much tractability in the explicit computation of portfolios. We solve the problem by explicitly recognizing the time-inconsistency of the mean-variance criterion and deriving a recursive representation for it, which makes dynamic programming applicable. We further show that our time-consistent solution is generically different from the pre-commitment solutions in the extant literature, which maximize the mean-variance criterion at an initial date and which the investor commits to follow despite incentives to deviate. We illustrate the usefulness of our analysis by explicitly computing dynamic mean-variance portfolios under various stochastic investment opportunities in a straightforward way, which does not involve solving a Hamilton-Jacobi-Bellman differential equation. A calibration exercise shows that the mean-variance hedging demands may comprise a significant fraction of the investor's total risky asset demand.


11/20:

Heterogeneity, Bounded Rationality and Market Dysfunctionality

Date:

2008-10-01

By:

Xue-Zhong He (School of Finance and Economics, University of Technology, Sydney)
Lei Shi (School of Finance and Economics, University of Technology, Sydney)

URL:

http://d.repec.org/n?u=RePEc:uts:rpaper:233&r=cbe

As the main building blocks of the modern finance theory, homogeneity and rational expectation have faced difficulty in explaining many market anomalies, stylized factors, and market inefficiency in empirical studies. As a result, heterogeneity and bounded rationality have been used as an alterative paradigm of asset price dynamics and this paradigm has been widely recognized recently in both academic and financial market practitioners. Within the framework of Chiarella, Dieci and He (2006a, 2006b) on mean-variance analysis under heterogeneous beliefs in terms of either the payoffs or returns of the risky assets, this paper examines the effect of the heterogeneity. We first demonstrate that, in market equilibrium, the standard one fund theorem under homogeneous belief does not held under heterogeneous belief in general, however, the optimal portfolios of investors are very close to the market efficient frontier. By imposing certain distribution assumption on the heterogeneous beliefs, we then use Monte Carlo simulations to show that certain heterogeneity among investors can improve the Sharpe and Treynor ratios of the portfolios and investors can benefit from the diversity in investors? beliefs. We also show that non-normality of market equilibrium return distributions is an outcome of the market aggregation of individual investors who make rational decisions based on their beliefs. Our results explain the empirical funding that that managed funds under-perform the market index on average and show that heterogeneity can improve the market efficiency.


11/16:

Herd Behavior in Financial Markets: An Experiment with Financial Market Professionals

Date:

2008-06-06

By:

Antonio Guarino
Marco Cipriani

URL:

http://d.repec.org/n?u=RePEc:imf:imfwpa:08/141&r=cbe

We study herd behavior in a laboratory financial market with financial market professionals. We compare two treatments, one in which the price adjusts to the order flow so that herding should never occur, and one in which event uncertainty makes herding possible. In the first treatment, subjects herd seldom, in accordance with both the theory and previous experimental evidence on student subjects. A proportion of subjects, however, engage in contrarianism, something not accounted for by the theory. In the second treatment, the proportion of herding decisions increases, but not as much as theory suggests; moreover, contrarianism disappears altogether.

Keywords:

Capital markets , Price controls , Economic models , Data analysis ,


Words Speak Louder Than Money

Date:

2008-10-29

By:

Maroš Servátka (University of Canterbury)
Steven Tucker (University of Canterbury)
Radovan VadoviÄ

URL:

http://d.repec.org/n?u=RePEc:cbt:econwp:08/18&r=cbe

This paper reports on an experiment studying the effectiveness of two types of mechanisms for promoting trust: pecuniary and non-pecuniary as well as their mutual interaction. Our data provide evidence that both mechanisms significantly enhance trust in comparison to the standard investment game. However, we find that the pecuniary mechanism performs significantly worse than the non-pecuniary one. Our results also point to the fact that pecuniary mechanism, which depends on monetary incentives, can be counterproductive when combined with mechanism which relies primarily on psychological incentives.

 

"The Risk of Divorce and Household Saving Behavior" Free Download

We analyze the impact of an increase in the risk of divorce on the saving behaviour of married couples. From a theoretical perspective, the expected sign of the effect is ambiguous. We take advantage of the legalization of divorce in Ireland in 1996 as an exogenous increase in the likelihood of marital dissolution. We analyze the saving behaviour over time of couples who were married before the law was passed. We propose a difference-in-differences approach where we use as comparison groups either married couples in other European countries (not affected by the law change), or Irish families who did not experience a significant increase in the expected risk of divorce (such as very religious families, or single individuals). Our results suggest that the increase in the risk of divorce brought about by the law was followed by an increase in the propensity to save of married couples, consistent with a rise in precautionary savings interpretation. An increase in the risk of marital dissolution of about 40 percent led to a 7 to 13 percent rise in the proportion of married couples reporting positive savings.

10/26: "Building Flexibility into the Irrevocable Life Insurance Trust" 

One of the most effective estate planning tools is the irrevocable life insurance trust. The trust keeps the proceeds of life insurance out of the estate of the insured but in exchange, the insured must give up control over the life insurance policy. Most irrevocable insurance trusts need to last for many years both before the decedent dies and after. In that time, many things will change and the insurance trust should be drafted with as much flexibility as possible without causing inclusion of the trust in the estate of the insured. This article discussed some of the ways to make an irrevocable life insurance trust as flexible as possible so that the client will be comfortable committing to this effective planning idea.

10/26 "Deferred Annuities and Strategic Asset Allocation" Free Download

We derive the optimal portfolio choice and consumption pattern over the lifecycle for households facing labor income, capital market, and mortality risk. In addition to stocks and bonds, households also have access to deferred annuities. Deferred annuities offer a hedge against mortality risk and provide similar benefits as Social Security. We show that a considerable fraction of wealth should be annuitized to skim the return enhancing mortality credit. The remaining liquid wealth (stocks and bonds) is used to hedge labor income risk during work life and to earn the equity premium. We find a marginal difference between a strategy involving deferred annuities and one where the investor can purchase immediate life annuities.


10/19:

"Hedge Fund Replication"

Date:

2008-09

By:

Akihiko Takahashi (Faculty of Economics, University of Tokyo)
Kyo Yamamoto (Graduate School of Economics, University of Tokyo)

URL:

http://d.repec.org/n?u=RePEc:tky:fseres:2008cf592&r=fmk

This chapter provides a comprehensive explanation of hedge fund replication. This chapter first reviews the characteristics of hedge fund returns. Then, the emergence of hedge fund replication products is discussed. Hedge fund replication methods are classified into three categories: Rule-based, Factor-based, and Distribution replicating approaches. These approaches attempt to capture different aspects of hedge fund returns. This chapter explains the three methods.


10/19:

Stages of the Ongoing Global Financial Crisis: Is There a Wandering Asset Bubble?

Date:

2008-09

By:

Lucjan T. Orlowski

URL:

http://d.repec.org/n?u=RePEc:iwh:dispap:11-08&r=fmk

This study argues that the severity of the current global financial crisis is strongly influenced by changeable allocations of the global savings. This process is named a “wandering asset bubble”. Since its original outbreak induced by the demise of the subprime mortgage market and the mortgage-backed securities in the U.S., this crisis has reverberated across other credit areas, structured financial products and global financial institutions. Four distinctive stages of the crisis are identified: the meltdown of the subprime mortgage market, spillovers into broader credit market, the liquidity crisis epitomized by the fallout of Bear Sterns with some contagion effects on other financial institutions, and the commodity price bubble. Monetary policy responses aimed at stabilizing financial markets are proposed.


10/14:  STOLI A TIA white paper examining the economics of Stranger-Originated Life Insurance (STOLI) transactions foretold more than two years ago that life expectancy calculations were untenable and would change on one or both sides of the STOLI transaction. STOLI (also known as Investor Originated Life Insurance or IOLI) transactions, unlike stand-alone life settlements, generally involve the issuance and settlement of a policy initiated by an investor who lacks an insurable interest in the insured. A STOLI transaction typically involves a life insurance company, a life settlement provider, and a special-purpose lender providing premium financing. 
        STOLI is fundamentally a "mortality futures" transaction in which the different parties involved in the transaction have different expectations about the future value of the article of trade in the futures contract. This article of trade in STOLI is the life expectancy of the insured. This life expectancy or “LE” is calculated one way by the life insurance companies on issuance of a life insurance policy and then calculated differently for the life settlement market-maker and premium-financing lender for settlement purposes. The longer the LE calculation by the life insurer, the lower and more attractive the premium. The shorter the LE calculation for the life-settlement market maker, the more they can offer to purchase a policy. Of course, only one of these LE calculations can be correct. 
        While certain life insurers appear to have modestly changed their LE calculations over the past few years (i.e., premiums for certain products have increased over the past few years), 21st Services, a major independent provider of LE evaluations in the secondary insurance market, recently dropped a "bombshell" by announcing the substantial lengthening of its LE determinations by up to 35%, which adversely impacts many life settlement offers by even more than 35% and renders many other policies un-sellable at all for reasons discussed below. This announcement has affected both STOLI and life settlement and premium financing transactions as market participants scramble to adjust to the change.

"The Determinants of Stock and Bond Return Comovements" Free Download

We study the economic sources of stock-bond return comovement and its time variation using a dynamic factor model. We identify the economic factors employing structural and non-structural vector autoregressive models for economic state variables such as interest rates, (expected) inflation, output growth and dividend payouts. We also view risk aversion, and uncertainty about inflation and output as additional potential factors. Even the best fitting economic factor model fits the dynamics of stock-bond correlations poorly. Alternative factors, such as liquidity proxies, help explain the residual correlations not explained by the economic models.

Knock yourself out

:
10/13:"The Role of the Annuity's Value on the Decision (Not) to Annuitize: Evidence from a Large Policy Change" 
Free Download
CESifo Working Paper Series No. 2376

This paper presents new evidence on how the annuitization decision is affected by changes in the annuity's value. We take advantage of an unprecendented change in policy, which in 2004 moderated the super-mandatory Swiss occupational pension scheme: The 20 percent reduction in the rate at which retirement capital is translated into a life-long annuity equates to a net present value loss of approximately 20'000 SFR (20'000 US$) for the average retiree. Using administrative data and correcting for anticipation effects, we show that due to the change in policy there was an approximately 8 percentage point change in the share of men choosing to annuitize their savings. We also show that the estimated responsiveness of the cash-out decision to variations in a utility based measure for the annuity value is comparable to results of previous studies, which employed completely different sources of variation in the annuity's value.

The Panic of 2007

Date:

2008-09

By:

Gary B. Gorton

URL:

http://d.repec.org/n?u=RePEc:nbr:nberwo:14358&r=fmk

How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.


10/10/08:

  1. Nonverbal language – the weapon of the insurance agent

Date:

2008

By:

Mitu, Narcis Eduard

URL:

http://d.repec.org/n?u=RePEc:pra:mprapa:10771&r=cbe

Within the insurance process, the person who insures as well as the person who wishes to buy an insurance policy must control well enough the communication techniques. In deed, the insurance is grounded on communication. Various scientific researches showed that most people involved in a business are very careful to what they say and the way they say it. Along with the way we speak, in the insurance field as well as in other many fields we tried to emplasize the necessity of ackowledging and controlling the nonverbal communication techiniques.

Keywords:

nonverbal communication; insurance.

JEL:

D70 D83 G20

 

9/1:  Macroeconomic Volatility and Stock Market Volatility, World-Wide

Date:

2008-08-06

By:

Francis X. Diebold (Department of Economics, University of Pennsylvania and NBER)
Kamil Yilmaz (Department of Economics, Koc University)

URL:


Notwithstanding its impressive contributions to empirical financial economics, there remains a significant gap in the volatility literature, namely its relative neglect of the connection between macroeconomic fundamentals and asset return volatility. We progress by analyzing a broad international cross section of stock markets covering approximately forty countries. We find a clear link between macroeconomic fundamentals and stock market volatilities, with volatile fundamentals translating into volatile stock markets.

8/26:Risk Aversion and Physical Prowess: Prediction, Choice and Bias

Date:

2008

By:

Sheryl Ball
Catherine C. Eckel
Maria Heracleous

URL:


This paper reports on experiments where individuals are asked to make risky decisions for themselves as well as predicting the risky decisions of others. Prior research has generally shown that people expect women to be more risk averse than men and that they, in fact are - a result we also find. We ask whether this is a pure gender effect or whether there is more to this result. In particular, both evolutionary and economic theories suggest that physically stronger decision makers should make riskier decisions, suggesting physical prowess as an underlying cause of gender differences. These experiments explore whether risk aversion is associated with a number of measures of real and perceived physical prowess. We find that forecasters consistently predict the types of risky decision produced by both gender and physical prowess, but often at magnitudes that significantly exaggerate than actual differences. Sources of bias are also examined, showing that specific characteristics of the target and predictor lead to over-estimation or under-estimation of risk preferences.

 

8/10: 1) Signal or Noise? Implications of the Term Premium for Recession Forecasting,†by Joshua V. Rosenberg and Samuel Maurer (Economic Policy Review, July 2008)

1) Signal or Noise? Implications of the Term Premium for Recession Forecasting, by Joshua V. Rosenberg and Samuel Maurer
Since the 1970s, an inverted yield curve has been a reliable signal of an imminent recession. One interpretation of this signal is that markets expect monetary policy to ease as the Federal Reserve responds to an upcoming deterioration in economic conditions. Some have argued that the yield curve inversion in August 2006 did not signal an imminent recession, but instead was triggered by an unusually low level of the term premium. This article examines whether changes in the term premium can distort the recession signal given by an inverted yield curve. The authors use the Kim and Wright (2005) decomposition of the term spread into an expectations component and a term premium component to compare recession forecasting models with and without the term premium. They find that the expectations component of the term spread is a leading indicator of recession, while the term premium component is not. Their analysis of recession forecasting performance provides some evidence that a model based on the expectations component is more accurate than the standard model that uses the term spread.

Ongoing efforts to find the best method for predicting recessions leave many questions unresolved. Existing papers propose a variety of indicators and modeling techniques, yet overall forecast accuracy has been mixed (see, for example, Stock and Watson [2003]). One approach with an excellent track record is the term spread model of Estrella and Hardouvelis (1991).1 When the yield on a three-month Treasury bill rises higher than the yield on a ten-year Treasury note, the model forecasts that a recession will begin twelve months in the future.
Why should a negative term spread predict a recession?
The expectations hypothesis posits that long-term interest rates are determined by expected future short-term rates. Because short-term rates are governed by monetary policy, investors should expect declines as a phase of monetary tightening transitions to monetary easing. As expected future short-term rates fall below current short-term rates, the yield curve inverts. Estrella and Adrian (2008) show that the yield-curve inversion that comes at the end of a tightening cycle has historically been followed by a decline in real activity, which provides a compelling link between yield-curve inversion and an imminent recession.

7/9:Time-Varying Incentives in the Mutual Fund Industry

Date:

2008-06

By:

Olivier, Jacques
Tay, Anthony

URL:

http://d.repec.org/n?u=RePEc:cpr:ceprdp:6893&r=fmk

This paper re-examines the incentives of mutual fund managers arising from investor flows. We provide evidence that the convexity of the flow-performance relationship varies with economic activity. We show that the effect is economically large and is not driven by abnormal years. We test two possible channels through which this pattern may arise. We investigate implications of the time-varying convexity for the incentives of managers to alter strategically the risk of their portfolios. We provide evidence that poor mid-year performers increase the risk of the portfolio only when economic activity is strong. Finally, we briefly discuss some methodological implications.

7/8:Time-Varying Incentives in the Mutual Fund Industry

Date:

2008-06

By:

Olivier, Jacques
Tay, Anthony

URL:

http://d.repec.org/n?u=RePEc:cpr:ceprdp:6893&r=fmk

This paper re-examines the incentives of mutual fund managers arising from investor flows. We provide evidence that the convexity of the flow-performance relationship varies with economic activity. We show that the effect is economically large and is not driven by abnormal years. We test two possible channels through which this pattern may arise. We investigate implications of the time-varying convexity for the incentives of managers to alter strategically the risk of their portfolios. We provide evidence that poor mid-year performers increase the risk of the portfolio only when economic activity is strong. Finally, we briefly discuss some methodological implications.


6/22: "The Retirement-Consumption Puzzle: Actual Spending Change in Panel Data" Free Download

The simple one-good model of life-cycle consumption requires that consumption be continuous over retirement; yet prior research based on partial measures of consumption or on synthetic panels indicates that spending drops at retirement, a result that has been called the retirement-consumption puzzle. Using panel data on total spending, nondurable spending and food spending, the authors find that spending declines at small rates over retirement, at rates that could be explained by mechanisms such as the cessation of work-related expenses, unexpected retirement due to a health shock or by the substitution of time for spending. In the low-wealth population where spending did decline at higher rates, the main explanation for the decline appears to be a high rate of early retirement due to poor health. They conclude that at the population level there is no retirement-consumption puzzle in their data, and that in subpopulations where there were substantial declines, conventional economic theory can provide the main explanation.

6/22:"The Timing of Redistribution" Free Download

We investigate whether late redistribution programs that can be targeted towards low income families can "dominate" early redistribution programs that cannot be targeted due to information constraints. We use simple two- period OLG models with heterogenous agents under six policy regimes: A model calibrated to the U.S. economy (benchmark), two early redistribution (lump sum) regimes, two (targeted) late redistribution regimes, and finally a model without taxes and redistribution. Redistribution programs are financed by a labor tax on the young and a capital tax on the old generation. We argue that late redistribution, if the programs are small in size, can dominate early redistribution in terms of welfare but not in terms of real output. Better targeting of low income households cannot offset savings distortions. In addition we find that optimal tax policy includes a positive capital tax rate.

We investigate whether late redistribution programs that can be targeted towards low income families can "dominate" early redistribution programs that cannot be targeted due to information constraints. We use simple two- period OLG models with heterogenous agents under six policy regimes: A model calibrated to the U.S. economy (benchmark), two early redistribution (lump sum) regimes, two (targeted) late redistribution regimes, and finally a model without taxes and redistribution. Redistribution programs are financed by a labor tax on the young and a capital tax on the old generation. We argue that late redistribution, if the programs are small in size, can dominate early redistribution in terms of welfare but not in terms of real output. Better targeting of low income households cannot offset savings distortions. In addition we find that optimal tax policy includes a positive capital tax rate.

5/20: Trouble Ahead – The Subprime Crisis as Evidence of a New Regime in the Stock Market

The results reveal that a major change is occurring for the last decade, imposing a new dynamic structure marked by frequent crashes. As Fig.2 shows, the crashes concentrate in the period after 1997. This di®erence in the empirically described evolution suggests that in the period of the easy interest rates, the 'Internet boom' and the housing bubble, a new regime was generated, giving birth to a new phase of turbulence in the ¯nancial markets. Distortion e®ects occurring on the market e®ective dimensions provide useful insight on the structure of the markets as it is revealed under shocks.
Here we show that the characterization of the distribution of the correlation strengths between stocks provides additional informational on the mutation in the structure of the market, suggesting that the prominences emerging in the market shape during crisis correspond to groups of companies that move following sectoral dynamics, in an even stronger synchronization.
The results shed a new light on the subprime crisis since August 2007 through the Winter 2008, and suggests that it is not a simple speculative shock. As the data and the stochastic geometry suggest, this ongoing turbulence is part of a mutation in the structure of the market since around 1997. The new structure has generated deeper and more frequent episodes of crises. The trouble is ahead.
5/20: I want some: The Federal Reserve is supplying the financial system with more than $150 billion in cash, a liquidity cushion that has helped keep enough credit flowing to ensure the economy's growth. After another auction of term funds on May 19, the amount of cash from the Fed will probably top $175 billion. And if the system needs still more, Fed Chairman Ben S. Bernanke said in a May 13 speech, the Fed stands ready to supply it. The financial turmoil stemming from the subprime mortgage debacle has caused most banks to tighten their standards for lending to households and businesses. The 325-basis-point reduction in the Fed's target for the overnight lending rate and the unprecedented amount of cash pumped into the system have helped the economy defy predictions of a recession.


5/7:  When Herding and Contrarianism Foster Market Efficiency : A Financial Trading Experiment
While herding has long been suspected to play a role in financial market booms and busts, theoretical analyses have struggled to identify conclusive causes for the effect. Recent theoretical work shows that informational herding is possible in a market with efficient asset prices if information is bi-polar, and contrarianism is possible with single-polar information. We present an experimental test for the validity of this theory, contrasting with all existing experiments where rational herding was theoretically impossible and subsequently not observed. Overall we observe that subjects generally behave according to theoretical predictions, yet the fit is lower for types who have the theoretical potential to herd. While herding is often not observed when predicted by theory, herding (sometimes irrational) does occur. Irrational contrarianism in particular leads observed prices to substantially differ from the efficient benchmark. Alternative models of behavior, such as risk aversion, loss aversion or error correction, either perform quite poorly or add little to our understanding