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2006, 23
A resampling method based on the bootstrap and a bias-correction step is developed for improving the Value-at-Risk (VaR) forecasting ability of the normal-GARCH model. Compared to the use of more sophisticated GARCH models, the new method is fast, easy to implement, numerically reliable, and, except for having to choose a window length L for the bias-correction step, fully data driven. The results for several different financial asset returns over a long out-of-sample forecasting period, as well as use of simulated data, strongly support use of the new method, and the performance is not sensitive to the choice of L. Klassifizierung: C22, C53, C63, G12
2006, 19
We use data from several waves of the Survey of Consumer Finances to document credit and debit card ownership and use across US demographic groups. We then present recent theoretical and empirical contributions to the study of credit and debit card behavior. Utilization rates of credit lines and portfolios of card holders present several puzzles. Credit line increases initiated by banks lead households to restore previous utilization rates. High-interest credit card debt co-exists with substantial holdings of low-interest liquid assets and with accumulation of retirement assets. Although available evidence disputes ignorance of credit card terms by card holders, redit card rates do not respond to competition. There is a rising trend in bankruptcy and delinquency, partly attributable to an increased tendency of households to declare bankruptcy associated with reduced social stigma, ease of procedures, and financial incentives. Co-existence of credit card debt with retirement assets can be explained through self-control hyperbolic discounting. Strategic default motives contribute partly to observed co-existence of credit card debt with low-interest liquid assets. A framework of “accountant-shopper” households, in which a rational accountant tries to control an impulsive shopper, seems consistent with both types of co-existence and with observed utilization of credit lines. JEL Classification: G11, E21
2006, 20
Baby boomer retirement security: the roles of planning, financial literacy and housing wealth
(2006)
We compare wealth holdings across two cohorts of the Health and Retirement Study: the early Baby Boomers in 2004, and individuals in the same age group in 1992. Levels and patterns of total net worth have changed relatively little over time, though Boomers rely more on housing equity than their predecessors. Most important, planners in both cohorts arrive close to retirement with much higher wealth levels and display higher financial literacy than non-planners. Instrumental variables estimates show that planning behavior can explain the differences in savings and why some people arrive close to retirement with very little or no wealth. Klassifizierung: D91, E21
2006, 18
This paper employs a multi-country large scale Overlapping Generations model with uninsurable labor productivity and mortality risk to quantify the impact of the demographic transition towards an older population in industrialized countries on world-wide rates of return, international capital flows and the distribution of wealth and welfare in the OECD. We find that for the U.S. as an open economy, rates of return are predicted to decline by 86 basis points between 2005 and 2080 and wages increase by about 4.1%. If the U.S. were a closed economy, rates of return would decline and wages increase by less. This is due to the fact that other regions in the OECD will age even more rapidly; therefore the U.S. is “importing” the more severe demographic transition from the rest of the OECD in the form of larger factor price changes. In terms of welfare, our model suggests that young agents with little assets and currently low labor productivity gain, up to 1% in consumption, from higher wages associated with population aging. Older, asset-rich households tend to lose, because of the predicted decline in real returns to capital. Klassifizierung: E17, E25, D33, C68
2006, 17
When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks’ assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting. Klassifizierung: G21, G22, M41
2006, 24
Assumptions about the dynamic and distributional behavior of risk factors are crucial for the construction of optimal portfolios and for risk assessment. Although asset returns are generally characterized by conditionally varying volatilities and fat tails, the normal distribution with constant variance continues to be the standard framework in portfolio management. Here we propose a practical approach to portfolio selection. It takes both the conditionally varying volatility and the fat-tailedness of risk factors explicitly into account, while retaining analytical tractability and ease of implementation. An application to a portfolio of nine German DAX stocks illustrates that the model is strongly favored by the data and that it is practically implementable. Klassifizierung: C13, C32, G11, G14, G18
2006, 21
In this paper we quantitatively characterize the optimal capital and labor income tax in an overlapping generations model with idiosyncratic, uninsurable income shocks, where households also differ permanently with respect to their ability to generate income. The welfare criterion we employ is ex-ante (before ability is realized) expected (with respect to uninsurable productivity shocks) utility of a newborn in a stationary equilibrium. Embedded in this welfare criterion is a concern of the policy maker for insurance against idiosyncratic shocks and redistribution among agents of different abilities. Such insurance and redistribution can be achieved by progressive labor income taxes or taxation of capital income, or both. The policy maker has then to trade off these concerns against the standard distortions these taxes generate for the labor supply and capital accumulation decision. We find that the optimal capital income tax rate is not only positive, but is significantly positive. The optimal (marginal and average) tax rate on capital is 36%, in conjunction with a progressive labor income tax code that is, to a first approximation, a flat tax of 23% with a deduction that corresponds to about $6,000 (relative to an average income of households in the model of $35,000). We argue that the high optimal capital income tax is mainly driven by the life cycle structure of the model whereas the optimal progressivity of the labor income tax is due to the insurance and redistribution role of the income tax system. Klassifizierung: E62, H21, H24
2006, 12
We model the impact of bank mergers on loan competition, reserve holdings and aggregate liquidity. A merger changes the distribution of liquidity shocks and creates an internal money market, leading to financial cost efficiencies and more precise estimates of liquidity needs. The merged banks may increase their reserve holdings through an internalization effect or decrease them because of a diversification effect. The merger also affects loan market competition, which in turn modifies the distribution of bank sizes and aggregate liquidity needs. Mergers among large banks tend to increase aggregate liquidity needs and thus the public provision of liquidity through monetary operations of the central bank. JEL Classification: G24, G32, G34
2006, 16
In this paper, we show the pivotal role business owners play in estimating the importance of the precautionary saving motive. The fact that business owners hold higher-than-average wealth while facing higher income risk than other households leads to a correlation between wealth and labor income risk regardless of whether or not a precautionary motive is important. Using data from the Panel Study of Income Dynamics in the 1980s and the 1990s, we show that within separate samples of both business owners and non-business owners the size of precautionary savings with respect to labor income risk is modest and accounts for less than ten percent of total household wealth. However, pooling together these two groups leads to an artificially high estimate of the importance of precautionary savings. Data from the Survey of Consumer Finances further confirms that precautionary savings account for less than ten percent of total wealth for both business owners and non-business owners. Thus, while a precautionary saving motive exists and affects all households, it does not give rise to high amounts of wealth in the economy, particularly among those households who face the most volatile labor earnings. Klassifizierung: D91
2006, 15
We evaluate the importance of the precautionary saving motive by relying on a direct question about precautionary wealth from the 1995 and 1998 waves of the Survey of Consumer Finances. In this survey, a new question has been designed to elicit the amount of desired precautionary wealth. This allows us to assess the amount of precautionary accumulation and to overcome many of the problems of previous works on this topic. We find that a precautionary saving motive exists and affects virtually every type of household. However, precautionary savings account for only 8 percent of total wealth holdings. Even though this motive does not give rise to large amounts of wealth, particularly for young and middle-age households, it is particularly important for two groups: older households and business owners. Overall, we provide strong evidence that we need to take the precautionary saving motive into account when modeling saving behavior. Klassifizierung: D91, E21, C21
2006, 13
This paper compares the boom-bust cycle in Finland and Sweden 1984-1995 with the average boom-bust pattern in industrialized countries as calculated from an international sample for the period 1970-2002. Two clear conclusions emerge. First, the Finnish-Swedish experience is much more volatile than the average boom-bust pattern. This holds for virtually every time series examined. Second, the bust and the recovery in the two Nordic countries differ markedly more from the international pattern than the boom phase does. The bust is considerably deeper and the recovery comes earlier and is more rapid. We explain the highly volatile character of the Finnish and Swedish boom-bust episode by the design of economic policies in the 1980s and 1990s. The boom-bust cycle in Finland and Sweden 1984-1995 was driven by financial liberalization and a hard currency policy, causing large pro-cyclical swings in the real rate of interest transmitted via the financial sector into the real sector and then into the public finances. JEL Classification: E32, E62, E63
2006, 14
Several recent studies have addressed household participation in the stock market, but relatively few have focused on household stock trading behavior. Household trading is important for the stock market, as households own more than 40% of the NYSE capitalization directly and can also influence trading patterns of institutional investors by adjusting their indirect stock holdings. Existing studies based on administrative data offer conflicting results. Discount brokerage data show excessive trading to the detriment of stockholders, while data on retirement accounts indicate extreme inactivity. This paper uses data representative of the population to document the extent of household portfolio inertia and to link it to household characteristics and to stock market movements. We document considerable portfolio inertia, as regards both changing stockholding participation status and trading stocks, and find that specific household characteristics contribute to the tendency to exhibit such inertia. Although our findings suggest some dependence of trading directly-held equity through brokerage accounts on the performance of the stock market index, they do not indicate that the recent expansion in the stockholder base and the experience of the stock market downswing have significantly altered the overall propensity of households to trade in stocks or to switch participation status in a way that could contribute to stock market instability. JEL Classification: G110, E210
2006, 01
Market efficiency today
(2006)
This CFS Working Paper has been presented at the CFSsymposium "Market Efficiency Today" held in Frankfurt/Main on October 6, 2005. In 2004 the Center for Financial Studies (CFS) in cooperation with the Johann Wolfgang Goethe University, Frankfurt/Main established an international academic prize, which is to be known as The Deutsche Bank Prize in Financial Economics. The prize will honor an internationally renowned researcher who has excelled through influential contributions to research in the fields of finance and money and macroeconomics, and whose work has lead to practice and policy-relevant results. The Deutsche Bank Prize in Financial Economics has been awarded for the first time in October 2005. The prize, sponsored by the Stiftungsfonds Deutsche Bank im Stifterverband für die Deutsche Wissenschaft, carries a cash award of € 50,000. The prize will be awarded every two years and the prize holder will be appointed a "Distinguished Fellow" of the CFS. The role of media partner for the Deutsche Bank Prize in Financial Economics is to be filled by the internationally renowned publication, The Economist and the Handelsblatt, the leading German-language financial and business newspaper.
2005, 23
Market discipline for financial institutions can be imposed not only from the liability side, as has often been stressed in the literature on the use of subordinated debt, but also from the asset side. This will be particularly true if good lending opportunities are in short supply, so that banks have to compete for projects. In such a setting, borrowers may demand that banks commit to monitoring by requiring that they use some of their own capital in lending, thus creating an asset market-based incentive for banks to hold capital. Borrowers can also provide banks with incentives to monitor by allowing them to reap some of the benefits from the loans, which accrue only if the loans are in fact paid o.. Since borrowers do not fully internalize the cost of raising capital to the banks, the level of capital demanded by market participants may be above the one chosen by a regulator, even when capital is a relatively costly source of funds. This implies that capital requirements may not be binding, as recent evidence seems to indicate. JEL Classification: G21, G38
2005, 22
We explore the macro/finance interface in the context of equity markets. In particular, using half a century of Livingston expected business conditions data we characterize directly the impact of expected business conditions on expected excess stock returns. Expected business conditions consistently affect expected excess returns in a statistically and economically significant counter-cyclical fashion: depressed expected business conditions are associated with high expected excess returns. Moreover, inclusion of expected business conditions in otherwise standard predictive return regressions substantially reduces the explanatory power of the conventional financial predictors, including the dividend yield, default premium, and term premium, while simultaneously increasing R2. Expected business conditions retain predictive power even after controlling for an important and recently introduced non-financial predictor, the generalized consumption/wealth ratio, which accords with the view that expected business conditions play a role in asset pricing different from and complementary to that of the consumption/wealth ratio. We argue that time-varying expected business conditions likely capture time-varying risk, while time-varying consumption/wealth may capture time-varying risk aversion. Klassifikation: G12
2005, 21
We provide a novel benefit of "Alternative Risk Transfer" (ART) products with parametric or index triggers. When a reinsurer has private information about his client's risk, outside reinsurers will price their reinsurance offer less aggressively. Outsiders are subject to adverse selection as only a high-risk insurer might find it optimal to change reinsurers. This creates a hold-up problem that allows the incumbent to extract an information rent. An information-insensitive ART product with a parametric or index trigger is not subject to adverse selection. It can therefore be used to compete against an informed reinsurer, thereby reducing the premium that a low-risk insurer has to pay for the indemnity contract. However, ART products exhibit an interesting fate in our model as they are useful, but not used in equilibrium because of basis-risk. Klassifikation: D82, G22
2005, 29
The paper documents lack of awareness of financial assets in the 1995 and 1998 Bank of Italy Surveys of Household Income and Wealth. It then explores the determinants of awareness, and finds that the probability that survey respondents are aware of stocks, mutual funds and investment accounts is positively correlated with education, household resources, long-term bank relations and proxies for social interaction. Lack of financial awareness has important implications for understanding the stockholding puzzle and for estimating stock market participation costs. Klassifikation: E2, D8, G1
2005, 32
We find that on average consumers chose the contract that ex post minimized their net costs. A substantial fraction of consumers (about 40%) still chose the ex post sub-optimal contract, with some incurring hundreds of dollars of avoidable interest costs. Nonetheless, the probability of choosing the sub-optimal contract declines with the dollar magnitude of the potential error, and consumers with larger errors were more likely to subsequently switch to the optimal contract. Thus most of the errors appear not to have been very costly, with the exception that a small minority of consumers persists in holding substantially sub-optimal contracts without switching. Klassifikation: G11, G21, E21, E51
2005, 25
Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises. Klassifikation: G21, G22
2005, 27
Trusting the stock market
(2005)
We provide a new explanation to the limited stock market participation puzzle. In deciding whether to buy stocks, investors factor in the risk of being cheated. The perception of this risk is a function not only of the objective characteristics of the stock, but also of the subjective characteristics of the investor. Less trusting individuals are less likely to buy stock and, conditional on buying stock, they will buy less. The calibration of the model shows that this problem is sufficiently severe to account for the lack of participation of some of the richest investors in the United States as well as for differences in the rate of participation across countries. We also find evidence consistent with these propositions in Dutch and Italian micro data, as well as in cross country data. Klassifikation: D1, D8