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Institute
- Center for Financial Studies (CFS) (115) (remove)
We investigate the relationship between anchoring and the emergence of bubbles in experimental asset markets. We show that setting a visual anchor at the fundamental value (FV) in the first period only is sufficient to eliminate or to significantly reduce bubbles in laboratory asset markets. If no FV-anchor is set, bubble-crash patterns emerge. Our results indicate that bubbles in laboratory environments are primarily sparked in the first period. If prices are initiated around the FV, they stay close to the FV over the entire trading horizon. Our insights can be related to initial public offerings and the interaction between prices set on pre-opening markets and subsequent intra-day price dynamics.
Do markets correct individual behavioral biases? In an experimental asset market, we compare the outcomes of a standard market economy to those of a an island economy that removed market interactions. We observe asset price bubbles in the market economy while prices are stable in the island economy. We also find that subjects took more risk following larger losses, resulting in larger prices and consistent with a gambling for resurrection motive. This motive can translate into bubbles in the market economy because higher prices increase average losses and thus reinforce the desire to resurrect. By contrast, the absence of such a strategic complementarity in island economies can explain the more stable outcome. These results suggest that markets do not correct behavioral biases, rather the contrary.
In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes affect liquidity provision and asset prices. Investors face a trade-off between risk and return. At the benefit of a potentially higher return, they can entrust their money to a trader. However this investment is risky, as the trader might not be trustworthy. Alternatively, they can opt for a safe but low return. We study how subjects solve this trade-off when traders are either liable for losses or not, and when their bonuses are either capped or not. Limited liability introduces a conflict of interest because it makes traders value the asset more than investors. To limit losses, investors should thus restrict liquidity provision to force traders to trade at a lower price. By contrast, bonus caps make traders value the asset less than investors. This should encourage liquidity provision and decrease prices. In contrast to these predictions, we find that under limited liability investors contribute to asset price bubbles by increasing liquidity provision and that caps fail to tame bubbles. Overall, giving investors skin in the game fosters financial stability.
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on quantities known only in the true model. We apply our method to a calibrated affine model. Our findings are threefold: Jumps matter more, i.e. our approximation is less accurate, if (i) the expected jump size or (ii) the jump intensity is large. Fixing the average impact of jumps, we find that (iii) rare, but severe jumps matter more than frequent, but small jumps.
We present a network model of the interbank market in which optimizing risk averse banks lend to each other and invest in non-liquid assets. Market clearing takes place through a tâtonnement process which yields the equilibrium price, while traded quantities are determined by means of a matching algorithm. We compare three alternative matching algorithms: maximum entropy, closest matching and random matching. Contagion occurs through liquidity hoarding, interbank interlinkages and fire sale externalities. The resulting network configurations exhibits a core-periphery structure, dis-assortative behavior and low clustering coefficient. We measure systemic importance by means of network centrality and input-output metrics and the contribution of systemic risk by means of Shapley values. Within this framework we analyze the effects of prudential policies on the stability/efficiency trade-off. Liquidity requirements unequivocally decrease systemic risk but at the cost of lower efficiency (measured by aggregate investment in non-liquid assets); equity requirements tend to reduce risk (hence increase stability) without reducing significantly overall investment.
Research on interbank networks and systemic importance is starting to recognise that the web of exposures linking banks balance sheets is more complex than the single-layer-of-exposure paradigm. We use data on exposures between large European banks broken down by both maturity and instrument type to characterise the main features of the multiplex structure of the network of large European banks. This multiplex network presents positive correlated multiplexity and a high similarity between layers, stemming both from standard similarity analyses as well as a core-periphery analyses of the different layers. We propose measures of systemic importance that fit the case in which banks are connected through an arbitrary number of layers (be it by instrument, maturity or a combination of both). Such measures allow for a decomposition of the global systemic importance index for any bank into the contributions of each of the sub-networks, providing a useful tool for banking regulators and supervisors. We use the dataset of exposures between large European banks to illustrate the proposed measures.
We develop a dynamic recursive model where political and economic decisions interact, to study how excessive debt-GDP ratios affect political sustainability of prudent fiscal policies. Rent seeking groups make political decisions – to cooperate (or not) – on the allocation of fiscal budgets (including rents) and issuance of sovereign debt. A classic commons problem triggers collective fiscal impatience and excessive debt issuing, leading to a vicious circle of high borrowing costs and sovereign default. We analytically characterize debt-GDP thresholds that foster cooperation among rent seeking groups and avoid default. Our analysis and application helps in understanding the politico-economic sustainability of sovereign rescues, emphasizing the need for fiscal targets and possible debt haircuts. We provide a calibrated example that quantifies the threshold debt-GDP ratio at 137%, remarkably close to the target set for private sector involvement in the case of Greece.
Against the background of the European debt crisis, the Research Center SAFE, in the fall of 2013, had issued a call for papers on the topic “Austerity and Economic Growth: Concepts for Europe”, with the objective of soliciting research proposals focusing on the nature of the relationship between austerity, debt sustainability and growth. Each of the five funded projects brought forth an academic paper and a shortened, non-technical policy brief. These policy papers are presented in the present collection of policy letters, edited by Alfons Weichenrieder.
The first paper by Alberto Alesina, Carlo Favero and Francesco Giavazzi looks into the question of how fiscal consolidations influence the real economy. Harris Dellas and Dirk Niepelt emphasize that fiscal austerity is a signal that investors use to tell apart governments with high and low default costs that accordingly will have a high or low probability of repayment.The paper by Benjamin Born, Gernot Müller and Johannes Pfeiffer,looks at the impact of austerity measures on government bond spreads. Oscar Jorda and Alan M. Taylor, in the fourth contribution, put into question whether the narrative records of fiscal consolidation plans are really exogenous. The final study by Enrique Mendoza, Linda Tesar and Jing Zhang suggests that fiscal consolidation should largely depend on expenditure cuts, rather than tax increases that may fail, when fiscal space is exhausted.
SAFE Newsletter : 2015, Q2
(2015)
SAFE Newsletter : 2015, Q4
(2015)
SAFE Newsletter : 2015, Q3
(2015)
SAFE Newsletter : 2015, Q1
(2015)