The societal benefit of a financial transaction tax

We provide a novel justification for a financial transaction tax for economies where agents face stochastic consumption opportunities. A financial transaction tax makes it more costly for agents to readjust their portfolios of liquid and illiquid assets in response to liquidity shocks, which increase both the demand for and the price of liquid assets. The higher price improves liquidity insurance and welfare for other market participants. We calibrate the model to U.S. data and find that the optimal financial transaction tax is 1.6% and that it reduces the volume of financial trading by 17%.     

Liquidity risk and bank portfolio management in a financial system without deposit insurance: Empirical evidence from prewar Japan

Using data from prewar Japan, this paper investigates the impact of a liquidity shock induced by depositors' behavior on bank portfolio management during financial crises in a system lacking deposit insurance. It is found that banks reacted to the liquidity shock sensitively through an increase in their cash holdings not by liquidating bank loans but by selling securities in the financial market. Moreover, banks exposed to local financial contagion adjusted the liquidity of their portfolio mainly by actively selling and buying their securities in the financial market. Finally, there is no evidence to conclude that the existence of the lender of last resort mitigated the liquidity constraints in bank portfolio adjustments.     

A Theory of Liquidity and Regulation of Financial Intermediation

This paper studies a Diamond–Dybvig model of providing insurance against unobservable liquidity shocks in the presence of unobservable trades. We show that competitive equilibria are inefficient. A social planner finds it beneficial to introduce a wedge between the interest rate implicit in optimal allocations and the economy's marginal rate of transformation. This improves risk sharing by reducing the attractiveness of joint deviations where agents simultaneously misrepresent their type and engage in trades on private markets. We propose a simple implementation of the optimum that imposes a constraint on the portfolio share that financial intermediaries invest in short-term assets.     

Liquidity shocks and equilibrium liquidity premia

We study an equilibrium in which agents face surprise liquidity shocks and invest in liquid and illiquid riskless assets. The random holding horizon from liquidity shocks makes the return of the illiquid security risky. The equilibrium premium for such risk depends on the constraint that agents face when borrowing against future income; it is insignificant without borrowing constraint, but can be very high with borrowing constraint. Illiquidity, therefore, can have large effects on asset returns when agents face liquidity shocks and borrowing constraints. This result can help us understand why some securities have high liquidity premia, despite low turnover frequency.     

Monetary policy and efficiency in over‐the‐counter financial trade

We develop a monetary model that incorporates over‐the‐counter (OTC) asset trade. After agents have made their money holding decisions, they receive an idiosyncratic shock that affects their valuation for consumption and, hence, for the unique liquid asset, namely money. Subsequently, agents can choose whether they want to enter the OTC market in order to sell assets and thus boost their liquidity or to buy assets and thus provide liquidity to other agents. In our model, inflation affects not only the money holding decisions of agents, as is standard in monetary theory, but also the entry decision of these agents in the financial market. We use our framework to study the effect of inflation on welfare, asset prices and OTC trade volume. In contrast to most monetary models, which predict a negative relationship between inflation and welfare, we find that inflation can be welfare improving within a certain range, because it mitigates a search externality that agents impose on one another when they make their OTC market entry decision. Also, an increase in the holding cost of money will lead to a decrease in asset prices, a regularity that is well documented in the data and often considered anomalous.     

PORTFOLIO REBALANCING AND ASSET PRICING WITH HETEROGENEOUS INATTENTION

Can households' inattention to the stock market quantitatively account for the inertia in portfolio rebalancing? I address this question by introducing an observation cost into a production economy with heterogeneous agents. In this environment, inattention changes endogenously over time and across agents. I find that inattention explains the inertia in portfolio rebalancing and its heterogeneity across households. Inattention also rationalizes the limited stock market participation observed in the data and improves the asset pricing performance of the model. Finally, I present a novel testable implication linking the effects of inattention on portfolio choices and asset prices to households' funding liquidity.     

Empirical tests on the asset pricing model with liquidity risk: An unobserved components approach

The aim of this paper is to test empirically the conditional liquidity-adjusted capital asset pricing model (L-CAPM) developed by Acharya and Pedersen (2005). Accordingly, we propose to estimate the L-CAPM using unobserved components methodology, which allows us to take into account the main stylized facts characterizing liquidity. Based on a sample of firms listed on the NASDAQ, our empirical analysis reveals several findings. Firstly, we show that liquidity is time-varying and exhibits strong seasonality. Secondly, we highlight the impact of the liquidity level premium on asset prices. Thirdly, we show that the most important liquidity risk is related to the covariance between portfolio illiquidity and market returns. Fourthly, we observe a negative relationship between portfolio returns and market illiquidity. Fifthly, we find that liquidity risk and illiquidity level are not always positively correlated.     

流动性供给、最后贷款人与金融系统稳定:一个次优选择

中央银行维护金融稳定的能力建立在其能够为市场提供流动性这一特有能力的基础之上。事实上,金融危机期间,各国央行一方面通过调整自身的资产负债表而创造流动性以支持金融系统正常运转;一方面动用最后贷款人职能对个别机构进行救助。需要注意的是,大规模流动性供给和救助行为并非是"最优"的选择,其对经济金融失衡的影响、对公平效率的损害,以及由此带来的通胀压力和政策外溢效应不容忽视。     

Model uncertainty and liquidity

Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a specific empirical model such as in derivative markets like the market for mortgage backed securities or credit derivatives. Moreover, the observed behavior of traders and institutions that places a large emphasis on “worst-case scenarios” through the use of “stress testing” and “Value-at-Risk” seems different than Savage expected utility would suggest. In this paper, we capture model-uncertainty using an Epstein and Wang [Epstein, L.G., Wang, T., 1994. Intertemporal asset pricing under Knightian uncertainty. Econometrica 62, 283–322] uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist financial intermediary makes a market for a propriety derivative security. The market-maker chooses bid and ask prices for the derivative, then, conditional on trade in this market, chooses an optimal portfolio and consumption. We explore how uncertainty can increase the bid–ask spread and, hence, reduces liquidity. Our infinite-horizon example produces short, dramatic decreases in liquidity even though the underlying environment is stationary. We show how these liquidity crises are closely linked to the uncertainty aversion effect on the optimal portfolio. Effectively, the uncertainty aversion can, at times, limit the ability of the market-maker to hedge a position and thus reduces the desirability of trade, and hence, liquidity.     

Financial crises and liquidity shocks a bank-run perspective

In contrast with the financial multiplier literature, this note explores a case in which the shock triggering a financial crisis stems from the financial sector itself; it is not a shock stemming from the real sector which gets amplified by, say, agency problems. The basic intuition is provided by the bank-run literature of the Diamond and Dybvig (1983) variety. Financial development is modeled as a mechanism that endows real assets (e.g., land and capital) with liquidity. However, liquidity can be impaired by shocks that are equivalent to a bank run. Liquidity creation enhances real asset prices, while a liquidity crunch generates asset price collapse. This bubble-looking episode is not driven by standard fundamentals, although it is fully in line with rationality. In this context, devoid of other frictions like price stickiness, the note examines the effect of monetary policy in the absence of nominal rigidities. It shows that preventing price deflation is not enough to offset relative (to output) asset price meltdown, but lower policy interest rates increase relative asset prices and steady-state output. Moreover, in the neighborhood of a first-best capital allocation, an increase in the liquidity of capital may lower the welfare of the representative individual, even if the higher liquidity of capital is sustainable and, hence, not destroyed by future crash – illustrating the possibility of “excessive” financial innovation. An extension of the basic model supports the conjecture that low policy interest rates may have given further incentives to the development of “shadow banking.”     

A comparison of cardinal tournaments and piece rate contracts with liquidity constrained agents

A celebrated result in the theory of tournaments is that relative performance evaluation (tournaments) is a superior compensation method to absolute performance evaluation (piece rate contracts) when the agents are risk-averse, the principal is risk-neutral or less risk-averse than the agents and production is subject to common shocks that are large relative to the idiosyncratic shocks. This is because tournaments get closer to the first best by filtering common uncertainty. This paper shows that, surprisingly, tournaments are superior even when agents are liquidity constrained so that transfers to them cannot fall short of a predetermined level. The rationale is that, by providing insurance against common shocks through a tournament, payments to the agents in unfavorable states increase and payments in favorable states decrease which enables the principal to satisfy tight liquidity constraints for the agents without paying any ex ante rents to them, while simultaneously providing higher-power incentives than under piece rates. The policy implication of our analysis is that firms should adopt relative performance evaluation over absolute performance evaluation regardless of whether the agents are liquidity (wealth) constrained or not.     

HOW HOUSEHOLD PORTFOLIOS EVOLVE AFTER RETIREMENT: THE EFFECT OF AGING AND HEALTH SHOCKS

We study how the portfolios of U.S. households evolve after retirement, using data from the Health and Retirement Study (HRS). In particular, we investigate the influence of aging and health shocks on a household's ownership of various assets and on the share of total assets held in each asset class. We find that households decrease their ownership of principal residences, vehicles, financial assets, businesses, and real estate as they age, while increasing the share of assets held in liquid assets and time deposits. We find that widowhood and other health shocks are associated with the same kinds of portfolio changes, and that the effect of shocks strengthens with time since the shock. Finally, we show that the effect of a shock is greatly magnified when households have physical or mental impairments. This suggests that factors other than standard risk and return considerations weigh heavily in many older households' portfolio decisions.     

Portfolio choice and pricing in illiquid markets

This paper studies portfolio choice and pricing in markets in which immediate trading may be impossible. It departs from the literature by removing restrictions on asset holdings, and finds that optimal positions depend significantly and naturally on liquidity: When expected future liquidity is high, agents take more extreme positions, given that they do not have to hold those positions for long when they become undesirable. Consequently, larger trades should be observed in markets with more frequent trading. Liquidity need not affect the price significantly, however, because liquidity has offsetting impacts on different agents' demands. This result highlights the importance of unrestricted portfolio choice. The paper draws parallels with the transaction-cost literature and clarifies the relationship between the price level and the realized trading frequency in this literature.     

Optimal asset taxes in financial markets with aggregate uncertainty

This paper studies Pareto-optimal risk-sharing arrangements in a private information economy with aggregate uncertainty and ex ante heterogeneous agents. I show how to implement Pareto optima as equilibria when agents can trade claims to consumption contingent on aggregate shocks in financial markets. The first result is that if aggregate and idiosyncratic shocks are independent, the implementation of optimal allocations does not require any interventions in financial markets. This result can be extended to dynamic settings in the sense that, in this case, only savings need to be distorted, but not trades in financial markets. Second, I characterize optimal trading distortions in financial markets when aggregate and idiosyncratic shocks are not independent. In this case, optimal asset taxes must be higher for those securities that pay out in aggregate states in which consumption is more volatile. For instance, this can provide an efficiency justification for the frequently observed differential tax treatment of different asset classes, such as debt and equity claims.     

Macroeconomic implications of financial policy

This paper studies the effects of financial policy in a model with heterogeneous agents, incomplete markets and portfolio restrictions. For an economy calibrated to replicate key aspects of the U.S. wealth distribution, we find that the quantitative effects of financial policy are relatively small. The reason is that the households determining aggregate behavior are relatively well insured and can therefore offset the actions of the firm by modifying their portfolio allocations. However, financial policy has important effects on asset prices. Whereas a higher level of debt in the capital structure of the firm introduces more risk into the economy by increasing the volatility of the equity return, it enhances the liquidity of households by increasing the supply of bonds. In an economy with a substantial amount of heterogeneity, this last effect dominates and leverage leads to a decrease in the equity premium. This is in contrast to the findings in representative agent models, in which leverage unambiguously increases the premium through a higher equity return volatility.     

Liquidity risk and financial competition: Implications for asset prices and monetary policy

This paper studies the implications of banking competition for capital markets and monetary policy. In particular, I develop a two-sector monetary growth model in which a group of agents is exposed to liquidity shocks and money is essential. Banks insure depositors against such risk and invest in the economy's assets. In this setting, I compare an economy with a perfectly competitive banking sector to an economy with a fully concentrated financial sector. Unlike previous work, banks can have market power in both deposits and capital markets. Compared to a perfectly competitive financial sector, I demonstrate that a monopolistic banking system can have substantial adverse consequences on capital formation, assets prices, and the degree of risk sharing. Furthermore, multiple steady-states can emerge and the economy becomes subject to poverty traps. More importantly, market power in financial markets may overturn the Tobin effect present under a perfectly competitive financial sector. This necessarily happens in economies with high degrees of liquidity risk and low levels of capital formation.     

Integrated Risk Management with a Filtered Bootstrap Approach

We present a multi-period risk model to measure portfolio risk that integrates market risk, credit risk and, in a simplified way, liquidity risk. Thus, it overcomes the major limitation currently shared by many risk models that are unable to give a complete picture of all portfolio risks according to a single, coherent framework. The model is based on the Filtered Bootstrap approach; hence, it captures conditional heteroskedasticity, serial correlation and non-normality in the risk factors, that is, most of the features of observed financial time series. Being a simulation risk model, it copes in a natural way with derivatives as it allows the full valuation of the probability density function of the contracts. In addition, it is a suitable and flexible way to generate future scenarios on medium‐term horizons, so this model is particularly appropriate for asset management companies.     

Liquidity and asset prices in rational expectations equilibrium with ambiguous information

The quality of information in financial asset markets is often hard to estimate. Reminiscent of the famous Ellsberg paradox, investors may be unable to form a single probability belief about asset returns conditional on information signals and may act on the basis of ambiguous (or multiple) probability beliefs. This paper analyzes information transmission in asset markets when agents?? information is ambiguous. We consider a market with risk-averse informed investors, risk-neutral competitive arbitrageurs, and noisy supply of the risky asset, first studied by Vives (Rev Financ Stud 8:3?C40, 1995a, J Econ Theory 67:178?C204, 1995b) with unambiguous information. Ambiguous information gives rise to the possibility of illiquid market where arbitrageurs choose not to trade in a rational expectations equilibrium. When market is illiquid, small informational or supply shocks have relatively large effects on asset prices.     

International Financial Liberalization and Economic Growth

This paper pulls together existing theory and evidence to assess whether international financial liberalization, by improving the functioning of domestic financial markets and banks, accelerates economic growth. The analysis suggests that the answer is "yes." First, liberalizing restrictions on international portfolio flows tends to enhance stock market liquidity. n turn, enhanced stock market liquidity accelerates economic growth primarily by boosting productivity growth. Second, allowing greater foreign bank presence tends to enhance the efficiency of the domestic banking system. In turn, better-developed banks spur economic growth primarily by accelerating productivity growth. Thus, international financial integration can promote economic development by encouraging improvements in the domestic financial system.     

Co-movement and spillovers: empirical evidence from BRIC equity markets

A higher degree of co-movement and spillover effects among different asset classes undermine portfolio diversification benefits. In this regard, the present study attempts to capture dynamic co-movement and return-volatility spillover effects among the most promising emerging equity markets, i.e. Brazil, Russia, India and China in a multivariate framework by employing VAR-ABEKK and VAR-DCC-AGARCH (1,1) models. To further comprehend the behaviour of the correlation coefficients during the global financial crisis period (2007–2009), heat map and Markov regime switching model (two regimes with a switch at ‘mean’ level only) have been used. The results report that the BRIC equity markets do not share a common stochastic trend in the long run. There is strong evidence of market shocks to volatility, volatility to volatility and negative shocks to volatility spillover effects among the BRIC markets. Overall, the BRIC markets are partially integrated with each other, thereby making them stronger investment candidates.