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2009, 08
We analyze a national sample of Americans with respect to their debt literacy, financial experiences, and their judgments about the extent of their indebtedness. Debt literacy is measured by questions testing knowledge of fundamental concepts related to debt and by selfassessed financial knowledge. Financial experiences are the participants’ reported experiences with traditional borrowing, alternative borrowing, and investing activities. Overindebtedness is a self-reported measure. Overall, we find that debt literacy is low: only about one-third of the population seems to comprehend interest compounding or the workings of credit cards. Even after controlling for demographics, we find a strong relationship between debt literacy and both financial experiences and debt loads. Specifically, individuals with lower levels of debt literacy tend to transact in high-cost manners, incurring higher fees and using high-cost borrowing. In applying our results to credit cards, we estimate that as much as one-third of the charges and fees paid by less knowledgeable individuals can be attributed to ignorance. The less knowledgeable also report that their debt loads are excessive or that they are unable to judge their debt position. JEL Classification: D14, D91
2009, 15
We model the motives for residents of a country to hold foreign assets, including the precautionary motive that has been omitted from much previous literature as intractable. Our model captures many of the principal insights from the existing specialized literature on the precautionary motive, deriving a convenient formula for the economy’s target value of assets. The target is the level of assets that balances impatience, prudence, risk, intertemporal substitution, and the rate of return. We use the model to shed light on two topical questions: The “upstream” flows of capital from developing countries to advanced countries, and the long-run impact of resorbing global financial imbalances
2009, 11
This paper analyzes the risk properties of typical asset-backed securities (ABS), like CDOs or MBS, relying on a model with both macroeconomic and idiosyncratic components. The examined properties include expected loss, loss given default, and macro factor dependencies. Using a two-dimensional loss decomposition as a new metric, the risk properties of individual ABS tranches can directly be compared to those of corporate bonds, within and across rating classes. By applying Monte Carlo Simulation, we find that the risk properties of ABS differ significantly and systematically from those of straight bonds with the same rating. In particular, loss given default, the sensitivities to macroeconomic risk, and model risk differ greatly between instruments. Our findings have implications for understanding the credit crisis and for policy making. On an economic level, our analysis suggests a new explanation for the observed rating inflation in structured finance markets during the pre-crisis period 2004-2007. On a policy level, our findings call for a termination of the 'one-size-fits-all' approach to the rating methodology for fixed income instruments, requiring an own rating methodology for structured finance instruments. JEL Classification: G21, G28
2009, 10
Algorithmic trading engines versus human traders – do they behave different in securities markets?
(2009)
After exchanges and alternative trading venues have introduced electronic execution mechanisms worldwide, the focus of the securities trading industry shifted to the use of fully electronic trading engines by banks, brokers and their institutional customers. These Algorithmic Trading engines enable order submissions without human intervention based on quantitative models applying historical and real-time market data. Although there is a widespread discussion on the pros and cons of Algorithmic Trading and on its impact on market volatility and market quality, little is known on how algorithms actually place their orders in the market and whether and in which respect this differs form other order submissions. Based on a dataset that – for the first time – includes a specific flag to enable the identification of orders submitted by Algorithmic Trading engines, the paper investigates the extent of Algorithmic Trading activity and specifically their order placement strategies in comparison to human traders in the Xetra trading system. It is shown that Algorithmic Trading has become a relevant part of overall market activity and that Algorithmic Trading engines fundamentally differ from human traders in their order submission, modification and deletion behavior as they exploit real-time market data and latest market movements.
2009, 14
We present a tractable model of the effects of nonfinancial risk on intertemporal choice. Our purpose is to provide a simple framework that can be adopted in fields like representative-agent macroeconomics, corporate finance, or political economy, where most modelers have chosen not to incorporate serious nonfinancial risk because available methods were too complex to yield transparent insights. Our model produces an intuitive analytical formula for target assets, and we show how to analyze transition dynamics using a familiar Ramsey-style phase diagram. Despite its starkness, our model captures most of the key implications of nonfinancial risk for intertemporal choice.
2009, 09
The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters’ push to extend FVA into other areas. In this article, we highlight four important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or U.S. GAAP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Fourth, although it is difficult to fault the FVA standards per se, implementation issues are a potential concern, especially with respect to litigation. Finally, we identify several avenues for future research. JEL Classification: G14, G15, G30, K22, M41, M42
2009, 12
American households have received a triple dose of bad news since the beginning of the current recession: The greatest collapse in asset values since the Great Depression, a sharp tightening in credit availability, and a large increase in unemployment risk. We present measures of the size of these shocks and discuss what a benchmark theory says about their immediate and ultimate consequences. We then provide a forecast based on a simple empirical model that captures the effects of wealth shocks and unemployment fears. Our short-term forecast calls for somewhat weaker spending, and somewhat higher saving rates, than the Consensus survey of macroeconomic forecasters. Over the longer term, our best guess is that the personal saving rate will eventually approach the levels that preceded period of financial liberalization that began in the late 1970s. Classification: C61, D11, E24
2009, 28
We investigate US households’ direct investment in stocks, bonds and liquid accounts and their foreign counterparts, in order to identify the different participation hurdles affecting asset investment domestically and overseas. To this end, we estimate a trivariate probit model with three further selection equations that allows correlations among unobservables of all possible asset choices. Our results point to the existence of a second hurdle that stock owners need to overcome in order to invest in foreign stocks. Among stockholders, we show that economic resources, willingness to assume greater financial risks, shopping around for the best investment opportunities all increase the probability to invest in foreign stocks. Furthermore, we find that households who seek financial advice from relatives, friends and work contacts are less likely to invest in foreign stocks. This result corroborates the conjecture by Hong et al. (2004) that social interactions should discourage investment in foreign stocks, given their limited popularity. On the other hand, we find little evidence for additional pecuniary or informational costs associated with investment in foreign bonds and liquid accounts. Finally, we show that ignoring correlations of unobservables across different asset choices can lead to very misleading results.
2009, 29
We investigate the effects of both trust and sociability for stock market participation, the role of which has been examined separately by existing finance literature. We use internationally comparable household data from the Survey of Health, Ageing and Retirement in Europe supplemented with regional information on generalized trust from the World Value Survey and on specific trust to financial institutions from Eurobarometer. We show that trust and sociability have distinct and sizeable positive effects on stock market participation and that sociability is likely to partly balance the discouragement effect on stockholding induced by low generalized trust in the region of residence. We also show that specific trust in advice given by financial institutions represents a prominent factor for stock investing, compared to other tangible features of the banking environment. Probing further into various groups of households, we find that sociability can induce stockholding among the less well off in Sweden, Denmark, and Switzerland where stock market participation is widespread. On the other hand, the effect of generalized trust is strong in countries with limited participation and low average trust like Austria, Spain, and Italy, offering an explanation for the remarkably low participation rates of the wealthy living therein.
2009, 19
In the New-Keynesian model, optimal interest rate policy under uncertainty is formulated without reference to monetary aggregates as long as certain standard assumptions on the distributions of unobservables are satisfied. The model has been criticized for failing to explain common trends in money growth and inflation, and that therefore money should be used as a cross-check in policy formulation (see Lucas (2007)). We show that the New-Keynesian model can explain such trends if one allows for the possibility of persistent central bank misperceptions. Such misperceptions motivate the search for policies that include additional robustness checks. In earlier work, we proposed an interest rate rule that is near-optimal in normal times but includes a cross-check with monetary information. In case of unusual monetary trends, interest rates are adjusted. In this paper, we show in detail how to derive the appropriate magnitude of the interest rate adjustment following a significant cross-check with monetary information, when the New-Keynesian model is the central bank’s preferred model. The cross-check is shown to be effective in offsetting persistent deviations of inflation due to central bank misperceptions. Keywords: Monetary Policy, New-Keynesian Model, Money, Quantity Theory, European Central Bank, Policy Under Uncertainty