Heterogeneity in Financial Market Participation: Appraising its Implications for the C-CAPM

This paper presents empirical evidence that accounting for heterogeneity in financial market participation is important for evaluating the empirical performance of the Consumption-based Capital Asset Pricing Model (C-CAPM). Using the US Consumer Expenditure Survey as a common testing ground, I re-assess three well-known characterizations of the equity premium puzzle (i) the inconsistency of the representative agent's IMRS with Hansen and Jagannathan bounds; (ii) Mehra and Prescott's calibration of a large representative agent's risk aversion; (iii) Hansen and the Singleton's large structural estimates of the preference parameters based on aggregate data. In all three cases, the estimates of risk aversion conditional upon financial market participation are not as far from reasonable values as the corresponding unconditional ones. The differences suggest that part of the equity premium puzzle can be accounted for by the use of a representative agent assumption rather than a more appropriate "representative stockholding agent assumption.     

Commercial Mortgage Default: A Comparison of Logit with Radial Basis Function Networks

This article explores the use of artificial neural networks in the modeling of foreclosure of commercial mortgages. The study employs a large set of individual loan histories previously used in the literature of proportional hazard models on loan default. Radial basis function networks are trained (estimated) using the same input variables as those used in the logistic. The objective is to demonstrate the use of networks in forecasting mortgage default and to compare their performance with that of the logistic benchmark in terms of prediction accuracy. Neural networks are shown to be superior to the logistic in terms of discriminating between good and bad loans. The study performs sensitivity analysis on the average loan and offers suggestions on further improving prediction of defaulting loans.     

The impact of settlement period on sales price

This study is an empirical investigation of the impact of settlement period on sales price while controlling for marketing period and standard explanatory variables. The hypothesized positive relationship between settlement period and sales price is confirmed by the results of this study. The estimated coefficient on settlement period is 0.0008 meaning that our market, on average, exacts a premium of 0.08 percent per day of settlement period beyond a norm of 60 days. The estimated coefficient on marketing period (a control variable) is –0.0003 meaning that our market, on average, requires a discount of 0.03 percent per day of marketing period. Our findings show the relative importance of settlement period in making real estate pricing decisions.     

The Impact of Risk-Based Premiums on FDIC-Insured Institutions

This paper examines the effect of a series of announcements leading to the approval of risk-based deposit insurance premiums on returns to stockholders of commercial banks. Utilizing risk-weighted capital ratios and measures of overall risk, we group banks according to one of the nine-tier insurance categories subsequently defined by the FDIC. During the period in which the new insurance system was considered and approved, we found that stockholders of well-capitalized, healthy banks experienced wealth changes significantly different from those experienced by less than well-capitalized, less than healthy banks. Although many argued the premium range in the initial insurance schedule was insufficient, the results show that this initial risk-basing marked an important change in the relative burdens imposed by FDIC insurance.     

Tax Competition, Income Differentials and Local Public Services

This paper examines strategic tax setting between fiscal authorities in the presence of mobile workers who locate across these jurisdictions in response to differing tax structures and congestable local public amenities. We find that the nature of the tax setting outcomes depend crucially on the proximity between cities. For distant cities with the same size populations, the pressure on tax rates of a more mobile workforce depends on the whether mobile workers are net beneficiaries or net contributors. If mobile workers are either high or low income earners, cities lower tax rates. If mobile workers are middle income earners, cities raise tax rates. For close or neighbouring cities, workers locate in one of the cities and tax rates and local public amenities are dispersed.     

Conduit Entities: Implications of Indirect Tax-Efficient Financing Structures for Real Investment

As well known, companies shift income from high to low tax jurisdictions. Typically, profit shifting is achieved by direct financing structures whereby companies use debt finance in the high tax entity and equity finance in the low tax entity. However, certain tax policies can lead to indirect financing structures whereby a conduit entity provides an opportunity to achieve at least two deductions for interest expenses for an investment made in the host country. The effect of direct and indirect financing structures on real investment is compared.     

Bank lending ‘manias’ in theory and history

A popular view of banking crises sees them as consequences of prior bank lending manias. Such manias are supposed to be especially likely in legally unrestricted banking systems, where banks can issue notes and are not subject to statutory reserve requirements. Here it is argued that the bank lending mania hypothesis (1) exaggerates the role of subjective factors, including bankers' confidence or optimism, as a stimulus to bank lending, and (2) is not supported by evidence from past, legally unrestricted banking systems.     

Interest-only and principal-only mortgage strips as interest-rate contingent claims

Interest-only (IO) and principal-only (PO) mortgage strips are valued in a stochastic interest-rate environment. The prepayment rate of the underlying mortgages is affected by two considerations not present in the pure financially rational model: (1) The property owner's holding period is assumed to follow a Gamma distribution, resulting in the possibility of prepayment due to the sale of the property (i.e., prepayment that is too early based on market interest rates); and (2) borrowers are assumed to face heterogeneous transaction costs related to refinancing the existing mortgage, and delay refinancing when market conditions make it optimal to do so (refinancing too late). Properties of IO/PO strips are identified by the finite difference method.     

Banks as Interest Rate Managers

Most banks have a two-tier pricing system, offering accounts at market-related interest rates and at posted rates that are changed at discrete intervals. In this paper, I develop a model of bank interest rate management. I consider a bank with two classes of loans and deposits in its balance sheet: One pays a market rate of interest, the other a posted rate. Market rates are exogenous and evolve stochastically over time. Posted rates are altered intermittently by the bank itself. The bank faces imperfect arbitrage by its customers between posted and market rate funds. Under simple assumptions about the stochastic process governing the market rate, I derive optimal decision rules for the adjustment of the posted rate and determine conditions under which these rules are asymmetric. A key prediction of the model is a negative correlation between market loan rates and the gap; this is more consistent with the behavior of British banks than is the contrary prediction of more standard models.     

German rail vehicle construction in the context of market globalisation

Conclusion In the guise of ABB Daimler-Benz Transportation and Siemens, Germany has two powerful systems suppliers in a good position to keep pace with other systems suppliers on global markets. As in the air-travel industry it is conceivable that developments are moving towards a uniform rail technology. Although the buy national principle still dominates procurement practices, and national egos still dominate the development of rail systems (ICE, TGV), growing competition from Japan could force Europe to develop a European system. This would significantly increase the chances of European industry in bidding for international contracts. For this reason the EU should not relent in its efforts to standardise European rail systems.     

A New Approach to Group Structure, Burden Sharing, and the Equilibrium Provision of Public Goods

In the received model of the voluntary provision of a pure public good, the usual practice is to proceed from assumptions about the group characteristics to inferences about an implied outcome. The approach advocated in this paper reverses the traditional direction. Assuming a Nash equilibrium, we ask how to characterize the diverse set of group characteristics which will support it. Approaching the problem from this angle we define three crucial characteristics of a group-equilibrium: consumer's free rider inducing supply, zero contribution-inducing wealth and voluntary surplus tribute which is the amount by which a person's actual income exceeds his/her zero-contribution inducing wealth. Defining these indicators we show how they form the foundation of a complete mapping between the distribution of individual characteristics of a group, and equilibrium public good supply. Certain questions such as the interaction between size of the group and heterogeneity of incomes and tastes not yet adequately addressed are shown to yield easily to this approach.     

Corporate Real Estate and Stock Market Performance

An interesting question in corporate real estate literature is whether real estate can improve the stock market performance of property-intensive non-real estate firms. Using a data set comprising 75 non-real estate corporations that own at least 20 percent properties, this paper empirically assesses and compares the pair-wise return, total risk, systematic risk and Jensen abnormal return performance of composite (with real estate) and hypothetical business (without real estate) firms. We employed Morgan Stanley Capital International world equity index instead of a local market index to provide some insights into the performance of the local market relative to the global market during the 1997–2001 volatile periods experienced by many Asian countries. Our results suggest the inclusion of real estate in a corporate portfolio appears to be associated with lower return, higher total risk, higher systematic risk and poorer abnormal return performance. It is therefore likely that non-real estate firms own properties for other reasons in addition to seeking improvement in their stock market performance. Further research is needed to explore the main factors contributing to corporate real estate ownership by non-real estate firms.     

“Investor sentiment” and the closed-end fund puzzle: A 7 percent solution

Lee, Shleifer, and Thaler (1991) argue that the irrational noise trader model of DeLong, Shleifer, Summers, and Waldmann (1990) ... is consistent with the published evidence on closed-end fund prices. ... However, Lee, Shleifer, and Thaler provide no indication of how much of the variability of a closed-end fund's discounts and premiums is due to such investor sentiment. Using the signal extraction technique of French and Roll (1986) to measure noise, this article estimates that on average only 7 percent of the variance of a standardized measure of weekly changes in discounts and premiums can be attributed to noise-trading activity. Investor sentiment, therefore, seems to account for very little of a closed-end fund's discount and premium variability over time.     

Do Market Makers Suffer from Splitting Headaches?

Studies of transactions surrounding stock split ex-dates often conclude that splitting firms either experience a decline or an improvement in their stock's liquidity, based on independent measures of trading costs and trading activity. In contrast, our evidence suggests that splits from outside into what often is deemed to be the optimal stock price range of $10.00 to $39.99 are nonevents for market makers: The spread-setting behavior of the market does not change after a split. Our analysis accounts for the interdependencies between bid-ask spreads and market microstructure effects and distinguishes between optimal and all other splitting firms.     

What is the Truth About the Scale of Japanese Banks' Bad Debts? Is the Situation Manageable?

In January 1998, the Japanese Ministry of Finance (MoF, 1998) released figures which suggested that the Japanese banking industry';s bad debts might be as high as ¥77 trillion (since revised upward to ¥87.5 trillion, if cooperative-type institutions are included; Financial Supervisory Agency (FSA), 1998). This compared with the previous official estimate of ¥28 trillion. The revelation was designed to do three things: (1) to convince investors, at home and abroad, who had long suspected that the true level of bad debts was much higher than the authorities (and the banks) were willing to admit to, that the authorities were sincere in their quest to enhance disclosure by local financial intermediaries; (2) to stifle opposition to the government's plans to use up to ¥30 trillion (since increased to ¥60 trillion) of public funds to stabilize the financial system¹ by underlining the gravity of the situation facing the Japanese economy; and (3) to pave the way for the introduction of more transparent reporting by the banks in April 1998 when a regime of prompt corrective action (PCA)² was scheduled to commence. This article explains the evolution of bad debt disclosure by the Japanese banking industry and assesses the significance of the latest figures. In particular, it highlights the extent to which accounting forbearance has been, and continues to be, used to mask the true level of the banks' bad debts and refutes the claim that the industry's bad debt burden peaked in 1995. The banking industry's ability to handle the continuing bad debt problem, in the face of a significant impairment of economic capital and the market's relentless drive for full disclosure and transparency, also is assessed.     

On Transitory Earnings

The paper develops a concept of transitory earnings and contrasts this source of earnings to core (or recurring) earnings. It is shown that any two of the following three attributes of transitory earnings imply the third: (i) forecasting irrelevance with respect to next-period aggregate earnings, (ii) value irrelevance, and (iii) unpredictability. The paper makes the case that the current dirty surplus items make sense, especially if one expands the valuation perspective to also allow for agency considerations.     

Adjustable Rate Mortgages: Valuation

A simulation method is employed to value Adustable Rate Mortgages, (ARMS). It is used to price two typical instruments: an ARM linked to a Treasury interest rate and an ARM linked to a Cost of Funds Index. Contractual provisions such as the margin over the index, caps and floors on the ARM's rate or on the monthly prepayment, reset frequency, and the teaser rate are examined for their influence on value. The effects of interest rate trend and volatility are also analysed.This paper was written when both authors were employees of Goldman, Sachs & Co. in New York.The material in this paper is for private information, and Goldman, Sachs & co. is not soliciting any action based on it. Opinions expressed are the authors present opinions only. The material is based upon information which Goldman, Sachs & Co. considers reliable; but it does not represent that the material is accurate or complete, and it should not be relied upon as such. Goldman, Sachs & Co. may from time to time have a long or short position in, and buy or sell, securities mentioned.     

Company Tax Structure and Company Tax Incidence

This paper reviews conflicting theories of company tax incidence impliedby the alternative new and traditional views of dividends andexamines their contrasting policy implications. Whereas, under thetraditional view, closer integration of the corporate and personalincome tax systems is suggested, an alternative policy orientationemphasizing the non-distorting features of the classical system is impliedby the new view. Even if the traditional view is accepted, theimplications for design and reform of the company tax vary widely underalternative specifications of domestic and international tax policy objectives. Schedular alternatives to global income taxation are alsoconsidered.     

Bid-ask bounce and speads in the foreign exchange futures market

This paper examines the intraday bid-ask bounce in Deutschemark and Japanese yen futures prices. The intraday Markovian bid-ask bounce process, which leads to a desirable equilibrium condition of reaching a bid or an ask transaction type with equal chances, is identified. A second-order Markov chain transition matrix model is used to derive a generalized estimator of bid-ask spreads in the foreign exchange futures market. It incorporates the conditional probabilities of a subsequent transaction being the same type as the current transaction's () and that of the next transaction being the same as the current type but different from the previous type (). The specification is {-Cov(P _t ,P _t+1 )/[(1–)(–)]}^1/2. The empirical results show that the average implied bid-ask spread is about $10, which is less than one tick's value of $12.50. It is also found that spreads are higher at the beginning and end of the trading day than the rest of the day, reflecting the uncertainty due to information flows and overnight inventory carrying costs, respectively.     

Forum Selection in International Business Contracts: Home Bias Portfolio Puzzle and Managerial Moral Hazard

We provide an economic analysis of forum selection in international business contracts. International business contracts or multi-state transactions within federally structured countries might be subject to more than one sovereign adjudication system. In case of conflict between the transacting parties, the appropriate tribunal must be identified. We examine the question of business firms' optimal choice of the forums to adjudicate future business disputes. We extend the investment model approach to litigation by applying a portfolio theory type analysis. We show that firms that prefer higher expected income and lower income volatility are better off diversifying the forums under which they litigate business disputes. This stands in contrast to real-world business practice that consistently shows a clear preference to selecting the home court and legal system to settle international business disputes. In a fraction of the cases, both parties gain by selecting a certain forum, because of specialization for example, and it becomes optimal to ignore diversification. In most cases, however, the relevant factors that affect forum selection are zero sum and priced ex ante, court bias, for example. Once priced, there is no incentive to disregard diversification. We hypothesize that, in addition to specialization, factors such as managerial moral hazard explain the real-world behavior of firms: managers are less likely to be blamed, ex post, for choosing the home court. We suggest that, as international barriers decline and international trade grows, firms will diversify the forums in which they adjudicate international business disputes.