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We selectively survey, unify and extend the literature on realized volatility of financial asset returns. Rather than focusing exclusively on characterizing the properties of realized volatility, we progress by examining economically interesting functions of realized volatility, namely realized betas for equity portfolios, relating them both to their underlying realized variance and covariance parts and to underlying macroeconomic fundamentals.
From a macroeconomic perspective, the short-term interest rate is a policy instrument under the direct control of the central bank. From a finance perspective, long rates are risk-adjusted averages of expected future short rates. Thus, as illustrated by much recent research, a joint macro-finance modeling strategy will provide the most comprehensive understanding of the term structure of interest rates. We discuss various questions that arise in this research, and we also present a new examination of the relationship between two prominent dynamic, latent factor models in this literature: the Nelson-Siegel and affine no-arbitrage term structure models. JEL Klassifikation: G1, E4, E5.
What do academics have to offer market risk management practitioners in financial institutions? Current industry practice largely follows one of two extremely restrictive approaches: historical simulation or RiskMetrics. In contrast, we favor flexible methods based on recent developments in financial econometrics, which are likely to produce more accurate assessments of market risk. Clearly, the demands of real-world risk management in financial institutions - in particular, real-time risk tracking in very high-dimensional situations - impose strict limits on model complexity. Hence we stress parsimonious models that are easily estimated, and we discuss a variety of practical approaches for high-dimensional covariance matrix modeling, along with what we see as some of the pitfalls and problems in current practice. In so doing we hope to encourage further dialog between the academic and practitioner communities, hopefully stimulating the development of improved market risk management technologies that draw on the best of both worlds.
This study offers a historical review of the monetary policy reform of October 6, 1979, and discusses the influences behind it and its significance. We lay out the record from the start of 1979 through the spring of 1980, relying almost exclusively upon contemporaneous sources, including the recently released transcripts of Federal Open Market Committee (FOMC) meetings during 1979. We then present and discuss in detail the reasons for the FOMC's adoption of the reform and the communications challenge presented to the Committee during this period. Further, we examine whether the essential characteristics of the reform were consistent with monetarism, new, neo, or old-fashioned Keynesianism, nominal income targeting, and inflation targeting. The record suggests that the reform was adopted when the FOMC became convinced that its earlier gradualist strategy using finely tuned interest rate moves had proved inadequate for fighting inflation and reversing inflation expectations. The new plan had to break dramatically with established practice, allow for the possibility of substantial increases in short-term interest rates, yet be politically acceptable, and convince financial markets participants that it would be effective. The new operating procedures were also adopted for the pragmatic reason that they would likely succeed. JEL Klassifikation: E52, E58, E61, E65.
The Basel Committee plans to differentiate risk-adjusted capital requirements between banks regulated under the internal ratings based (IRB) approach and banks under the standard approach. We investigate the consequences for the lending capacity and the failure risk of banks in a model with endogenous interest rates. The optimal regulatory response depends on the banks' inclination to increase their portfolio risk. If IRB-banks are well-capitalized or gain little from taking risks, then they will increase their market share and hold safe portfolios. As risk-taking incentives become more important, the optimal portfolio size of banks adopting intern rating systems will be increasingly constrained, and ultimately they may lose market share relative to banks using the standard approach. The regulator has only limited options to avoid the excessive adoption of internal rating systems. JEL Klassifikation: K13, H41.
We develop an estimated model of the U.S. economy in which agents form expectations by continually updating their beliefs regarding the behavior of the economy and monetary policy. We explore the effects of policymakers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted heretofore quiescent in inflation expectations and destabilized the economy. Had monetary policy reacted less aggressively to perceived unemployment gaps, in inflation expectations would have remained anchored and the stag inflation of the 1970s would have been avoided. Indeed, we find that less activist policies would have been more effective at stabilizing both in inflation and unemployment. We argue that policymakers, learning from the experience of the 1970s, eschewed activist policies in favor of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance of the U.S. economy.
Recent evidence on the effect of government spending shocks on consumption cannot be easily reconciled with existing optimizing business cycle models. We extend the standard New Keynesian model to allow for the presence of rule-of-thumb (non-Ricardian) consumers. We show how the interaction of the latter with sticky prices and deficit financing can account for the existing evidence on the effects of government spending. JEL Klassifikation: E32, E62.
In a plain-vanilla New Keynesian model with two-period staggered price-setting, discretionary monetary policy leads to multiple equilibria. Complementarity between the pricing decisions of forward-looking firms underlies the multiplicity, which is intrinsically dynamic in nature. At each point in time, the discretionary monetary authority optimally accommodates the level of predetermined prices when setting the money supply because it is concerned solely about real activity. Hence, if other firms set a high price in the current period, an individual firm will optimally choose a high price because it knows that the monetary authority next period will accommodate with a high money supply. Under commitment, the mechanism generating complementarity is absent: the monetary authority commits not to respond to future predetermined prices. Multiple equilibria also arise in other similar contexts where (i) a policymaker cannot commit, and (ii) forward-looking agents determine a state variable to which future policy respond. JEL Klassifikation: E5, E61, D78
The Basle securitisation framework explained: the regulatory treatment of asset securitisation
(2005)
The paper provides a comprehensive overview of the gradual evolution of the supervisory policy adopted by the Basle Committee for the regulatory treatment of asset securitisation. We carefully highlight the pathology of the new “securitisation framework” to facilitate a general understanding of what constitutes the current state of computing adequate capital requirements for securitised credit exposures. Although we incorporate a simplified sensitivity analysis of the varying levels of capital charges depending on the security design of asset securitisation transactions, we do not engage in a profound analysis of the benefits and drawbacks implicated in the new securitisation framework. JEL Klassifikation: E58, G21, G24, K23, L51. Forthcoming in Journal of Financial Regulation and Compliance, Vol. 13, No. 1 .
This paper analyzes the empirical relationship between credit default swap, bond and stock markets during the period 2000-2002. Focusing on the intertemporal comovement, we examine weekly and daily lead-lag relationships in a vector autoregressive model and the adjustment between markets caused by cointegration. First, we find that stock returns lead CDS and bond spread changes. Second, CDS spread changes Granger cause bond spread changes for a higher number of firms than vice versa. Third, the CDS market is significantly more sensitive to the stock market than the bond market and the magnitude of this sensitivity increases when credit quality becomes worse. Finally, the CDS market plays a more important role for price discovery than the corporate bond market. JEL Klassifikation: G10, G14, C32.
We characterize the response of U.S., German and British stock, bond and foreign exchange markets to real-time U.S. macroeconomic news. Our analysis is based on a unique data set of high-frequency futures returns for each of the markets. We find that news surprises produce conditional mean jumps; hence high-frequency stock, bond and exchange rate dynamics are linked to fundamentals. The details of the linkages are particularly intriguing as regards equity markets. We show that equity markets react differently to the same news depending on the state of the economy, with bad news having a positive impact during expansions and the traditionally-expected negative impact during recessions. We rationalize this by temporal variation in the competing "cash flow" and "discount rate" effects for equity valuation. This finding helps explain the time-varying correlation between stock and bond returns, and the relatively small equity market news effect when averaged across expansions and recessions. Lastly, relying on the pronounced heteroskedasticity in the high-frequency data, we document important contemporaneous linkages across all markets and countries over-and-above the direct news announcement effects. JEL Klassifikation: F3, F4, G1, C5
This paper analyzes banks' choice between lending to firms individually and sharing lending with other banks, when firms and banks are subject to moral hazard and monitoring is essential. Multiple-bank lending is optimal whenever the benefit of greater diversification in terms of higher monitoring dominates the costs of free-riding and duplication of efforts. The model predicts a greater use of multiple-bank lending when banks are small relative to investment projects, firms are less profitable, and poor financial integration, regulation and inefficient judicial systems increase monitoring costs. These results are consistent with empirical observations concerning small business lending and loan syndication. JEL Klassifikation: D82; G21; G32.
We analyze governance with a dataset on investments of venture capitalists in 3848 portfolio firms in 39 countries from North and South America, Europe and Asia spanning 1971-2003. We find that cross-country differences in Legality have a significant impact on the governance structure of investments in the VC industry: better laws facilitate faster deal screening and deal origination, a higher probability of syndication and a lower probability of potentially harmful co-investment, and facilitate board representation of the investor. We also show better laws reduce the probability that the investor requires periodic cash flows prior to exit, which is in conjunction with an increased probability of investment in high-tech companies. Klassifikation: G24, G31, G32.
A large literature over several decades reveals both extensive concern with the question of time-varying betas and an emerging consensus that betas are in fact time-varying, leading to the prominence of the conditional CAPM. Set against that background, we assess the dynamics in realized betas, vis-à-vis the dynamics in the underlying realized market variance and individual equity covariances with the market. Working in the recently-popularized framework of realized volatility, we are led to a framework of nonlinear fractional cointegration: although realized variances and covariances are very highly persistent and well approximated as fractionally-integrated, realized betas, which are simple nonlinear functions of those realized variances and covariances, are less persistent and arguably best modeled as stationary I(0) processes. We conclude by drawing implications for asset pricing and portfolio management. JEL Klassifikation: C1, G1
Earlier studies of the seigniorage inflation model have found that the high-inflation steady state is not stable under adaptive learning. We reconsider this issue and analyze the full set of solutions for the linearized model. Our main focus is on stationary hyperinflationary paths near the high-inflation steady state. The hyperinflationary paths are stable under learning if agents can utilize contemporaneous data. However, in an economy populated by a mixture of agents, some of whom only have access to lagged data, stable inflationary paths emerge only if the proportion of agents with access to contemporaneous data is sufficiently high. JEL Klassifikation: C62, D83, D84, E31
In this paper, we study the effectiveness of monetary policy in a severe recession and deflation when nominal interest rates are bounded at zero. We compare two alternative proposals for ameliorating the effect of the zero bound: an exchange-rate peg and price-level targeting. We conduct this quantitative comparison in an empirical macroeconometric model of Japan, the United States and the euro area. Furthermore, we use a stylized micro-founded two-country model to check our qualitative findings. We find that both proposals succeed in generating inflationary expectations and work almost equally well under full credibility of monetary policy. However, price-level targeting may be less effective under imperfect credibility, because the announced price-level target path is not directly observable. Klassifikation: E31, E52, E58, E61
We determine optimal monetary policy under commitment in a forwardlooking New Keynesian model when nominal interest rates are bounded below by zero. The lower bound represents an occasionally binding constraint that causes the model and optimal policy to be nonlinear. A calibration to the U.S. economy suggests that policy should reduce nominal interest rates more aggressively than suggested by a model without lower bound. Rational agents anticipate the possibility of reaching the lower bound in the future and this amplifies the effects of adverse shocks well before the bound is reached. While the empirical magnitude of U.S. mark-up shocks seems too small to entail zero nominal interest rates, shocks affecting the natural real interest rate plausibly lead to a binding lower bound. Under optimal policy, however, this occurs quite infrequently and does not require targeting a positive average rate of inflation. Interestingly, the presence of binding real rate shocks alters the policy response to (non-binding) mark-up shocks. JEL Klassifikation: C63, E31, E52 .
In this article, we investigate risk return characteristics and diversification benefits when private equity is used as a portfolio component. We use a unique dataset describing 642 US-American portfolio companies with 3620 private equity investments. Information about precisely dated cash flows at the company level enables for the first time a cash flow equivalent and simultaneous investment simulation in stocks, as well as the construction of stock portfolios for benchmarking purposes. With respect to the methodology involved, we construct private equity, stock-benchmark and mixed-asset portfolios using bootstrap simulations. For the late 1990s we find a dramatic increase in the extent to which private equity outperforms stock investment. In earlier years private equity was underperforming its stock benchmarks. Within the overall class of private equity, returns on earlier private equity investment categories, like venture capital, show on average higher variations and even higher rates of failure. It is in this category in particular that high average portfolio returns are generated solely by the ability to select a few extremely well performing companies, thus compensating for lost investments. There is a high marginal diversifiable risk reduction of about 80% when the portfolio size is increased to include 15 investments. When the portfolio size is increased from 15 to 200 there are few marginal risk diversification effects on the one hand, but a large increase in managing expenditure on the other, so that an actual average portfolio size between 20 and 28 investments seems to be well balanced. We provide empirical evidence that the non-diversifiable risk that a constrained investor, who is exclusively investing in private equity, has to hold exceeds that of constrained stock investors and also the market risk. From the viewpoint of unconstrained investors with complete investment freedom, risk can be optimally reduced by constructing mixed asset portfolios. According to the various private equity subcategories analyzed, there are big differences in optimal allocations to this asset class for minimizing mixed-asset portfolio variance or maximizing performance ratios. We observe optimal portfolio weightings to be between 3% and 65%.
We take a simple time-series approach to modeling and forecasting daily average temperature in U.S. cities, and we inquire systematically as to whether it may prove useful from the vantage point of participants in the weather derivatives market. The answer is, perhaps surprisingly, yes. Time-series modeling reveals conditional mean dynamics, and crucially, strong conditional variance dynamics, in daily average temperature, and it reveals sharp differences between the distribution of temperature and the distribution of temperature surprises. As we argue, it also holds promise for producing the long-horizon predictive densities crucial for pricing weather derivatives, so that additional inquiry into time-series weather forecasting methods will likely prove useful in weather derivatives contexts.
Despite powerful advances in yield curve modeling in the last twenty years, comparatively little attention has been paid to the key practical problem of forecasting the yield curve. In this paper we do so. We use neither the no-arbitrage approach, which focuses on accurately fitting the cross section of interest rates at any given time but neglects time-series dynamics, nor the equilibrium approach, which focuses on time-series dynamics (primarily those of the instantaneous rate) but pays comparatively little attention to fitting the entire cross section at any given time and has been shown to forecast poorly. Instead, we use variations on the Nelson-Siegel exponential components framework to model the entire yield curve, period-by-period, as a three-dimensional parameter evolving dynamically. We show that the three time-varying parameters may be interpreted as factors corresponding to level, slope and curvature, and that they may be estimated with high efficiency. We propose and estimate autoregressive models for the factors, and we show that our models are consistent with a variety of stylized facts regarding the yield curve. We use our models to produce term-structure forecasts at both short and long horizons, with encouraging results. In particular, our forecasts appear much more accurate at long horizons than various standard benchmark forecasts. JEL Code: G1, E4, C5
We consider three sets of phenomena that feature prominently - and separately - in the financial economics literature: conditional mean dependence (or lack thereof) in asset returns, dependence (and hence forecastability) in asset return signs, and dependence (and hence forecastability) in asset return volatilities. We show that they are very much interrelated, and we explore the relationships in detail. Among other things, we show that: (a) Volatility dependence produces sign dependence, so long as expected returns are nonzero, so that one should expect sign dependence, given the overwhelming evidence of volatility dependence; (b) The standard finding of little or no conditional mean dependence is entirely consistent with a significant degree of sign dependence and volatility dependence; (c) Sign dependence is not likely to be found via analysis of sign autocorrelations, runs tests, or traditional market timing tests, because of the special nonlinear nature of sign dependence; (d) Sign dependence is not likely to be found in very high-frequency (e.g., daily) or very low-frequency (e.g., annual) returns; instead, it is more likely to be found at intermediate return horizons; (e) Sign dependence is very much present in actual U.S. equity returns, and its properties match closely our theoretical predictions; (f) The link between volatility forecastability and sign forecastability remains intact in conditionally non-Gaussian environments, as for example with time-varying conditional skewness and/or kurtosis.
We extend the important idea of range-based volatility estimation to the multivariate case. In particular, we propose a range-based covariance estimator that is motivated by financial economic considerations (the absence of arbitrage), in addition to statistical considerations. We show that, unlike other univariate and multivariate volatility estimators, the range-based estimator is highly efficient yet robust to market microstructure noise arising from bid-ask bounce and asynchronous trading. Finally, we provide an empirical example illustrating the value of the high-frequency sample path information contained in the range-based estimates in a multivariate GARCH framework.
Financial theory creates a puzzle. Some authors argue that high-risk entrepreneurs choose debt contracts instead of equity contracts since risky but high returns are of relatively more value for a loan-financed firm. On the contrary, authors who focus explicitly on start-up finance predict that entrepreneurs are the more likely to seek equity-like venture capital contracts, the more risky their projects are. Our paper makes a first step to resolve this puzzle empirically. We present microeconometric evidence on the determinants of debt and equity financing in young and innovative SMEs. We pay special attention to the role of risk for the choice of the financing method. Since risk is not directly observable we use different indicators for financial and project risk. It turns out that our data generally confirms the hypothesis that the probability that a young high-tech firm receives equity financing is an increasing function of the financial risk. With regard to the intrinsic project risk, our results are less conclusive, as some of our indicators of a risky project are found to have a negative effect on the likelihood to be financed by private equity.
We study the returns the venture capital and private equity investment from 221 venture capital and private equity funds that are part of 72 venture capital and private equity firms, 5040 entrepreneurial firms (3826 venture capital and 1214 private equity), and spanning 32 years (1971 - 2003) and 39 countries from North and South America, Europe and Asia. We make use of four main categories of variables to proxy for value-added activities and risks that explain venture capital and private equity returns: market and legal environment, VC characteristics, entrepreneurial firm characteristics, and the characteristics and structure of the investment. We show Heckman sample selection issues in regards to both unrealized and partially realized investments are important to consider for analysing the determinants of realized returns. We further compare the actual unrealized returns, as reported to investment managers, to the predicted unrealized returns based on the estimates of realized returns from the sample selection models. We show there exists significant systematic biases in the reporting of unrealized investments to institutional investors depending on the level of the earnings aggressiveness and disclosure indices in a country, as well as proxies for the degree of information asymmetry between investment managers and venture capital and private equity fund managers. Klassifikation: G24, G28, G31, G32, G35
We analyze welfare maximizing monetary policy in a dynamic two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady-state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forward-looking and households' preferences are not restricted. In this context, we study optimal policy both in the long-run and along a dynamic path, and we compare optimal commitment policy under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation. Klassifikation: E52, F41 . This version: January, 2004. First draft: October 2003 .
This paper considers a theoretical model of n asymmetric firms that reduce their initial unit costs by spending on R&D activities. In accordance with Schumpeterian hypotheses we obtain that more efficient (bigger) firms spend more in R&D and this leads to a more concentrated market structure. We also find a positive relationship between innovation and market concentration. This calls for a corrective tax on R&D activities to curtail strategic incentives to over-invest in R&D trying to achieve a higher market share. Klassifikation: L11, L52, O31 . February, 2004.
This paper aims to analyze the impact of different types of venture capitalists on the performance of their portfolio firms around and after the IPO. We thereby investigate the hypothesis that different governance structures, objectives and track record of different types of VCs have a significant impact on their respective IPOs. We explore this hypothesis by using a data set embracing all IPOs which occurred on Germany's Neuer Markt. Our main finding is that significant differences among the different VCs exist. Firms backed by independent VCs perform significantly better two years after the IPO compared to all other IPOs and their share prices fluctuate less than those of their counterparts in this period of time. Obviously, independent VCs, which concentrated mainly on growth stocks (low book-to-market ratio) and large firms (high market value), were able to add value by leading to less post-IPO idiosyncratic risk and more return (after controlling for all other effects). On the contrary, firms backed by public VCs (being small and having a high book-to-market ratio) showed relative underperformance. Klassifikation: G10, G14, G24 . 29th January 2004 .
How might retirees consider deploying the retirement assets accumulated in a defined contribution pension plan? One possibility would be to purchase an immediate annuity. Another approach, called the "phased withdrawal" strategy in the literature, would have the retiree invest his funds and then withdraw some portion of the account annually. Using this second tactic, the withdrawal rate might be determined according to a fixed benefit level payable until the retiree dies or the funds run out, or it could be set using a variable formula, where the retiree withdraws funds according to a rule linked to life expectancy. Using a range of data consistent with the German experience, we evaluate several alternative designs for phased withdrawal strategies, allowing for endogenous asset allocation patterns, and also allowing the worker to make decisions both about when to retire and when to switch to an annuity. We show that one particular phased withdrawal rule is appealing since it offers relatively low expected shortfall risk, good expected payouts for the retiree during his life, and some bequest potential for the heirs. We also find that unisex mortality tables if used for annuity pricing can make women's expected shortfalls higher, expected benefits higher, and bequests lower under a phased withdrawal program. Finally, we show that delayed annuitization can be appealing since it provides higher expected benefits with lower expected shortfalls, at the cost of somewhat lower anticipated bequests. Klassifikation: G22, G23, J26, J32, H55 . January 2004.
This paper proposes an intertemporal model of venture capital investment with screening and advising where the venture capitalist´s time endowment is the scarce input factor. Screening improves the selection of firms receiving finance, advising allows firms to develop a marketable product, both have a variable intensity. In our setup, optimal linear contracts solves the moral hazard problem. Screening however asks for an entrepreneur wage and does not allow for upfront payments which would cause severe adverse selection. Project characteristics have implications for screening and advising intensity and the distribution of profits. Finally, we develop a formal version of the "venture capital cycle" by extending the basic setup to a simple model of venture capital supply and demand.
This paper analyses the effects of the Initial Public Offering (IPO) market on real investment decisions in emerging industries. We first propose a model of IPO timing based on divergence of opinion among investors and short-sale constraints. Using a real option approach, we show that firms are more likely to go public when the ratio of overvaluation over profits is high, that is after stock market run-ups. Because initial returns increase with the demand from optimistic investors at the time of the offer, the model provides an explanation for the observed positive causality between average initial returns and IPO volume. Second, we discuss the possibility of real overinvestment in high-tech industries. We claim that investing in the industry gives agents an option to sell the project on the stock market at an overvalued price enabling then the financing of positive NPV projects which would not be undertaken otherwise. It is shown that the IPO market can however also lead to overinvestment in new industries. Finally, we present some econometric results supporting the idea that funds committed to the financing of high-tech industries may respond positively to optimistic stock market valuations.
Equal size, equal role? : interest rate interdependence between the Euro area and the United States
(2003)
This paper investigates whether the degree and the nature of economic and monetary policy interdependence between the United States and the euro area have changed with the advent of EMU. Using real-time data, it addresses this issue from the perspective of financial markets by analysing the effects of monetary policy announcements and macroeconomic news on daily interest rates in the United States and the euro area. First, the paper finds that the interdependence of money markets has increased strongly around EMU. Although spillover effects from the United States to the euro area remain stronger than in the opposite direction, we present evidence that US markets have started reacting also to euro area developments since the onset of EMU. Second, beyond these general linkages, the paper finds that certain macroeconomic news about the US economy have a large and significant effect on euro area money markets, and that these effects have become stronger in recent years. Finally, we show that US macroeconomic news have become good leading indicators for economic developments in the euro area. This indicates that the higher money market interdependence between the United States and the euro area is at least partly explained by the increased real integration of the two economies in recent years.
Based on a broad set of regional aggregated and disaggregated consumer price index (CPI) data from major industrialized countries in Asia, North America and Europe we are examining the role that national borders play for goods market integration. In line with the existing literature we find that intra-national markets are better integrated than international market. Additionally, our results show that there is a large "ocean" effect, i.e., inter-continental markets are significantly more segmented than intra-continental markets. To examine the impact of the establishment of the European Monetary Union (EMU) on integration, we split our sample into a pre-EMU and EMU sample. We find that border effects across EMU countries have declined by about 80% to 90% after 1999 whereas border estimates across non-EMU countries have remained basically unchanged. Since global factors have affected all countries in our sample similarly and major integration efforts across EMU countries were made before 1999, we suggest that most of the reduction in EMU border estimates has been "nominal". Panel unit root evidence shows that the observed large differences in integration across intra- and inter-continental markets remain valid in the long-run. This finding implies that real factors are responsible for the documented segmentations across our sample countries.
We estimate a Bayesian vector autoregression for the U.K. with drifting coefficients and stochastic volatilities. We use it to characterize posterior densities for several objects that are useful for designing and evaluating monetary policy, including local approximations to the mean, persistence, and volatility of inflation. We present diverse sources of uncertainty that impinge on the posterior predictive density for inflation, including model uncertainty, policy drift, structural shifts and other shocks. We use a recently developed minimum entropy method to bring outside information to bear on inflation forecasts. We compare our predictive densities with the Bank of England's fan charts.
We show diverse beliefs is an important propagation mechanism of fluctuations, money non neutrality and efficacy of monetary policy. Since expectations affect demand, our theory shows economic fluctuations are mostly driven by varying demand not supply shocks. Using a competitive model with flexible prices in which agents hold Rational Belief (see Kurz (1994)) we show that (i) our economy replicates well the empirical record of fluctuations in the U.S. (ii) Under monetary rules without discretion, monetary policy has a strong stabilization effect and an aggressive anti-inflationary policy can reduce inflation volatility to zero. (iii) The statistical Phillips Curve changes substantially with policy instruments and activist policy rules render it vertical. (iv) Although prices are flexible, money shocks result in less than proportional changes in inflation hence the aggregate price level appears "sticky" with respect to money shocks. (v) Discretion in monetary policy adds a random element to policy and increases volatility. The impact of discretion on the efficacy of policy depends upon the structure of market beliefs about future discretionary decisions. We study two rationalizable beliefs. In one case, market beliefs weaken the effect of policy and in the second, beliefs bolster policy outcomes and discretion could be a desirable attribute of the policy rule. Since the central bank does not know any more than the private sector, real social gain from discretion arise only in extraordinary cases. Hence, the weight of the argument leads us to conclude that bank´s policy should be transparent and abandon discretion except for rare and unusual circumstances. (vi) An implication of our model suggests the current effective policy is only mildly activist and aims mostly to target inflation.
Permanent and transitory policy shocks in an empirical macro model with asymmetric information
(2003)
Despite a large literature documenting that the efficacy of monetary policy depends on how inflation expectations are anchored, many monetary policy models assume: (1) the inflation target of monetary policy is constant; and, (2) the inflation target is known by all economic agents. This paper proposes an empirical specification with two policy shocks: permanent changes to the inflation target and transitory perturbations of the short-term real rate. The public sector cannot correctly distinguish between these two shocks and, under incomplete learning, private perceptions of the inflation target will not equal the true target. The paper shows how imperfect policy credibility can affect economic responses to structural shocks, including transition to a new inflation target - a question that cannot be addressed by many commonly used empirical and theoretical models. In contrast to models where all monetary policy actions are transient, the proposed specification implies that sizable movements in historical bond yields and inflation are attributable to perceptions of permanent shocks in target inflation.
This paper investigates the role that imperfect knowledge about the structure of the economy plays in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and to update continuously their beliefs regarding the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interaction between monetary policy and economic outcomes. We find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public's expectations of inflation become uncoupled from the policy objective and stagflation results, in a pattern similar to that experienced in the United States during the 1970s. Our results highlight the value of effective communication of a central bank's inflation objective and of continued vigilance against inflation in anchoring inflation expectations and fostering macroeconomic stability. July 2003.
Monetary policy is sometimes formulated in terms of a target level of inflation, a fixed time horizon and a constant interest rate that is anticipated to achieve the target at the specified horizon. These requirements lead to constant interest rate (CIR)instrument rules. Using the standard New Keynesian model, it is shown that some forms of CIR policy lead to both indeterminacy of equilibria and instability under adaptive learning. However, some other forms of CIR policy perform better. We also examine the properties of the different policy rules in the presence of inertial demand and price behaviour.
Escapist policy rules
(2003)
We study a simple, microfounded macroeconomic system in which the monetary authority employs a Taylor-type policy rule. We analyze situations in which the self-confirming equilibrium is unique and learnable according to Bullard and Mitra (2002). We explore the prospects for the use of 'large deviation' theory in this context, as employed by Sargent (1999) and Cho, Williams, and Sargent (2002). We show that our system can sometimes depart from the self-confirming equilibrium towards a non-equilibrium outcome characterized by persistently low nominal interest rates and persistently low inflation. Thus we generate events that have some of the properties of "liquidity traps" observed in the data, even though the policymaker remains committed to a Taylor-type policy rule which otherwise has desirable stabilization properties.
The development of tractable forward looking models of monetary policy has lead to an explosion of research on the implications of adopting Taylor-type interest rate rules. Indeterminacies have been found to arise for some specifications of the interest rate rule, raising the possibility of inefficient fluctuations due to the dependence of expectations on extraneous "sunspots ". Separately, recent work by a number of authors has shown that sunspot equilibria previously thought to be unstable under private agent learning can in some cases be stable when the observed sunspot has a suitable time series structure. In this paper we generalize the "common factor "technique, used in this analysis, to examine standard monetary models that combine forward looking expectations and predetermined variables. We consider a variety of specifications that incorporate both lagged and expected inflation in the Phillips Curve, and both expected inflation and inertial elements in the policy rule. We find that some policy rules can indeed lead to learnable sunspot solutions and we investigate the conditions under which this phenomenon arises.
A financial system can only perform its function of channelling funds from savers to investors if it offers sufficient assurance to the providers of the funds that they will reap the rewards which have been promised to them. To the extent that this assurance is not provided by contracts alone, potential financiers will want to monitor and influence managerial decisions. This is why corporate governance is an essential part of any financial system. It is almost obvious that providers of equity have a genuine interest in the functioning of corporate governance. However, corporate governance encompasses more than investor protection. Similar considerations also apply to other stakeholders who invest their resources in a firm and whose expectations of later receiving an appropriate return on their investment also depend on decisions at the level of the individual firm which would be extremely difficult to anticipate and prescribe in a set of complete contingent contracts. Lenders, especially long-term lenders, are one such group of stakeholders who may also want to play a role in corporate governance; employees, especially those with high skill levels and firm-specific knowledge, are another. The German corporate governance system is different from that of the Anglo-Saxon countries because it foresees the possibility, and even the necessity, to integrate lenders and employees in the governance of large corporations. The German corporate governance system is generally regarded as the standard example of an insider-controlled and stakeholder-oriented system. Moreover, only a few years ago it was a consistent system in the sense of being composed of complementary elements which fit together well. The first objective of this paper is to show why and in which respect these characterisations were once appropriate. However, the past decade has seen a wave of developments in the German corporate governance system, which make it worthwhile and indeed necessary to investigate whether German corporate governance has recently changed in a fundamental way. More specifically one can ask which elements and features of German corporate governance have in fact changed, why they have changed and whether those changes which did occur constitute a structural change which would have converted the old insider-controlled system into an outsider-controlled and shareholder-oriented system and/or would have deprived it of its former consistency. It is the second purpose of this paper to answer these questions. Revised version forthcoming in "The German Financial System", edited by Jan P. Krahnen and Reinhard H. Schmidt, Oxford University Press.
A rapidly growing literature has documented important improvements in volatility measurement and forecasting performance through the use of realized volatilities constructed from high-frequency returns coupled with relatively simple reduced-form time series modeling procedures. Building on recent theoretical results from Barndorff-Nielsen and Shephard (2003c,d) for related bi-power variation measures involving the sum of high-frequency absolute returns, the present paper provides a practical framework for non-parametrically measuring the jump component in realized volatility measurements. Exploiting these ideas for a decade of high-frequency five-minute returns for the DM/$ exchange rate, the S&P500 market index, and the 30-year U.S. Treasury bond yield, we find the jump component of the price process to be distinctly less persistent than the continuous sample path component. Explicitly including the jump measure as an additional explanatory variable in an easy-to-implement reduced form model for realized volatility results in highly significant jump coefficient estimates at the daily, weekly and quarterly forecast horizons. As such, our results hold promise for improved financial asset allocation, risk management, and derivatives pricing, by separate modeling, forecasting and pricing of the continuous and jump components of total return variability.
While focusing on the protection of distressed sovereigns, the current debate intended to reform the International Financial Architecture has hardly addressed the protection of creditors rights that varies among laws. I suspect however that this constitutes an essential determinant of the success of suggested solutions, especially under the contractual approach. Based on a sample of bonds issued by developing countries states in the period, January 1987 to December 1997, I find that, for given contract characteristics (e.g. listing markets and currency), the governing law is selected according to its ability to enforce repayment. However, although the New York law seems looser and incur larger enforcement costs than the England&Wales law, the former permits equivalent yearly credit amounts. I interpret this as a consequence of the existence of a larger set of valuable assets (e.g. trade) in the US that constitute implicit securities. My findings yield important implications for the reforms. In particular, provided that there exists a seemingly equivalent enforcement credibility between England and New York laws, the prompt implementation of the contractual approach solution should constitute a valuable first step toward efficient sovereign debt markets. October 2003.
The paper suggests an innovative contribution to the investigation of banking liabilities pricing contracted by sovereign agents. To address fundamental issues of banking, the study focuses on the determinants of the up-front fees (the up-front fee is a charge paid out at the signature of the loan arrangement). The investigation is based on a uniquely extensive sample of bank loans contracted or guaranteed by 58 less-developed countries sovereigns in the period from 1983 to 1997. The well detailed reports allow for the calculation of the equivalent yearly margin on the utilization period for all individual loan. The main findings suggest a significant impact of the renegotiation and agency costs on front-end borrowing payments. Unlike the sole interest spread, the all-in interest margin better takes account of these costs. The model estimates however suggest the non-linear pricing is hardly associated with an exogenous split-up intended by the borrower and his banker to cover up information. Instead the up-front payment is a liquidity transfer as described by Gorton and Kahn (2000) to compensate for renegotiation and monitoring costs. The second interesting result is that banks demand payment for all types of sovereign risk in an identical manner public debt holders do. The difference is that, unlike bond holders, bankers have the possibility to charge an up-front fee to compensate for renegotiation costs. Hence, beyond the information related issues, the higher complexity of the pricing design makes bank loan optimal for lenders on sovereign capital markets, especially relative to public debt, thus motivating for their presence. The paper contributes to the expanding literature on loan syndication and banking related issues. The study also has relevance for the investigation of the developing countries debt pricing.
We present an analysis of VaR forecasts and P&L-series of all 13 German banks that used internal models for regulatory purposes in the year 2001. To this end, we introduce the notion of well-behaved forecast systems. Furthermore, we provide a series of statistical tools to perform our analyses. The results shed light on the forecast quality of VaR models of the individual banks, the regulator's portfolio as a whole, and the main ingredients of the computation of the regulatory capital required by the Basel rules.
We estimate a model with latent factors that summarize the yield curve (namely, level, slope, and curvature) as well as observable macroeconomic variables (real activity, inflation, and the stance of monetary policy). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and much weaker evidence for a reverse influence. We also relate our results to a traditional macroeconomic approach based on the expectations hypothesis.
Using the Johansen test for cointegration, we examine to which extent inflation rates in the Euro area have converged after the introduction of a single currency. Since the assumption of non-stationary variables represents the pivotal point in cointegration analyses we pay special attention to the appropriate identification of non-stationary inflation rates by the application of six different unit root tests. We compare two periods, the first ranging from 1993 to 1998 and the second from 1993 to 2002 with monthly observations. The Johansen test only finds partial convergence for the former period and no convergence for the latter.
Financial markets are to a very large extent influenced by the advent of information. Such disclosures, however, do not only contain information about fundamentals underlying the markets, but they also serve as a focal point for the beliefs of market participants. This dual role of information gains further importance for explaining the development of asset valuations when taking into account that information may be perceived individually (private information), or may be commonly shared by all traders (public information). This study investigates into the recently developed theoretical structures explaining the operating mechanism of the two types of information and emphasizes the empirical testability and differentiation between the role of private and public information. Concluding from a survey of experimental studies and own econometric analyses, it is argued that most often public information dominates private information. This finding justifies central bankers´ unease when disseminating news to the markets and argues against the recent trend of demanding full transparency both for financial institutions and financial markets themselves.
The paper describes the legal and economic environment of mergers and acquisitions in Germany and explores barriers to obtaining and executing corporate control. Various cases are used to demonstrate that resistance by different stakeholders including minority shareholders, organized labour and the government may present powerful obstacles to takeovers in Germany. In spite of the overall convergence of European takeover and securities trading laws, Germany still shows many peculiarities that make its market for corporate control distinct from other countries. Concentrated share ownership, cross shareholdings and pyramidal ownership structures are frequent barriers to acquiring majority stakes. Codetermination laws, the supervisory board structure and supermajority requirements for important corporate decisions limit the execution of control by majority shareholders. Bidders that disregard the German preference for consensual solutions and the specific balance of powers will risk their takeover attempt be frustrated by opposing influence groups. Revised version forthcoming in "The German Financial System", edited by Jan P. Krahnen and Reinhard H. Schmidt, Oxford University Press.
This paper is a draft for the chapter "German banks and banking structure" of the forthcoming book "The German financial system" edited by J.P. Krahnen and R.H. Schmidt (Oxford University Press). As such, the paper starts out with a description of past and present structural features of the German banking industry. Given the presented empirical evidence it then argues that great care has to be taken when generalising structural trends from one financial system to another. Whilst conventional commercial banking is clearly in decline in the US, it is far from clear whether the dominance of banks in the German financial system has been significantly eroded over the last decades. We interpret the immense stability in intermediation ratios and financing patterns of firms between 1970 and 2000 as strong evidence for our view that the way in which and the extent to which German banks fulfil the central functions for the financial system are still consistent with the overall logic of the German financial system. In spite of the current dire business environment for financial intermediaries we do not expect the German financial system and its banking industry as an integral part of this system to converge to the institutional arrangements typical for a market-oriented financial system.
We present a survey on the role of initial public offerings (Epos) and venture capital (VC) in Germany after the Second World War. Between 1945 and 1983 IPOs hardly played a role at all and only a minor role thereafter. In addition, companies that chose an IPO were much older and larger than the average companies going public for the first time in the US or the UK. The level of IPO underpricing in Germany, in contrast, has not been fundamentally different from that in other countries. The picture for venture capital financing is not much different from that provided by IPOs in Germany. For a long time venture capital financing was hardly significant, particularly as a source of early stage financing. The unprecedented boom on the Neuer Markt between 1997 and 2000, when many small venture capital financed firms entered the market, provides a striking contrast to the preceding era. However, by US standards, the levels of both IPO and venture capital activities remained rather low even in this boom phase. The extent to which recent developments will have a lasting impact on the financing of German firms, the level of IPO activity, and venture capital financing, remains to be seen. At the time of writing, activity has come to a near stand still and the Neuer Markt has just been dissolved. The low number of IPOs and the fairly low volume of VC financing in Germany before the introduction of the Neuer Markt are a striking and much debated phenomenon. Understanding the reasons for these apparent peculiarities is vital to understanding the German financial system. The potential explanations that have been put forward range from differentces in mentality to legal and institutional impediments and the availability of alternative sources of financing. Moreover the recent literature discusses how interest groups may have benefited and influenced the situation. These groups include politicians, unions/workers, managers/controlling-owners of established firms as well as banks. Revised version forthcoming in "The German Financial System", edited by Jan P. Krahnen and Reinhard H. Schmidt, Oxford University Press.