A STATISTICAL THEORY OF EQUILIBRIUM IN GAMES*

This paper describes a statistical model of equiliobrium behaviour in games, which we call Quantal Response Equilibrium (QRE). The key feature of the equilibrium is that individuals do not always play responses to the strategies of their opponents, but play better strategies with higher probability than worse strategies. we illustrate several different applications of this approach, and establish a number of theoretical properties of this equilibrium concept. We also demonstrate an equililance between this equilibrium notion and Bayesian games derived from games of complete information with perturbed payoffs     

Positively Weighted Portfolios on the Minimum-Variance Frontier

Duality theory is employed to provide necessary and sufficient conditions for portfolios on the minimum-variance frontier to have positive investment proportions in all assets. These conditions involve the feasibility of portfolios that have non-negative correlation with all assets and positive correlation with at least one. Using these results, several “qualitative” results concerning the signs of investment proportions in efficient portfolios are proved. It is argued that the conditions that ensure all-positive weights in efficient portfolios are intuitively compelling and are not unique to the CAPM. With large numbers of assets, however, the signs of weights in minimum-variance portfolios can be very sensitive to slight departures from these conditions due to, for example, sampling error.     

REGULATORY STRUCTURE, REGULATORY FAILURE, AND THE S& L DEBACLE

Widespread S & L failures during the 1980s required the federal government to spend over 100 billion dollars bailing out the deposit insurance fund. This paper interprets the S & L debacle as a regulatory failure. Review of the S & L debacle suggests that regulators failed to manage the deposit insurance system efficiently. But the regulatory agencies' structure appears to have played a secondary role in contributing to regulatory failure. Faced with the same incentives, objectives, and resources, regulators probably would have behaved similarly regardless of the regulatory structure.     

The Persistence and Pricing of the Cash Component of Earnings

Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments.     

Can Interest‐Bearing Money Circulate? A Small‐Denomination Arkansan Experiment, 1861–63

Legal restrictions theory suggests that dominance of non-interest-bearing currency is possible only because legal impediments prevent financial institutions from offering interest-bearing alternatives. A viable interest-bearing medium must be issued in denominations low enough for day-to-day use, however, and without historical examples of small-denomination interest-bearing issues we cannot properly test whether interest-bearing currency will circulate as legal restrictions theory predicts. Civil War Arkansas offers a rare instance where large quantities of small-denomination interest-bearing money were actually issued, mostly below $5. The results of this Arkansan experiment show that small-denomination interest-bearing issues can indeed function as the primary medium of exchange.     

Compensating Financial Experts

We propose a labor market model in which financial firms compete for a scarce supply of workers who can be employed as either bankers or traders. While hiring bankers helps create a surplus that can be split between a firm and its trading counterparties, hiring traders helps the firm appropriate a greater share of that surplus away from its counterparties. Firms bid defensively for workers bound to become traders, who then earn more than bankers. As counterparties employ more traders, the benefit of employing bankers decreases. The model sheds light on the historical evolution of compensation in finance.     

Orderly exits from adjustable pegs and exchange rate bands

This paper examines the exit process from adjustable pegs and exchange rate bands, and the role of capital flows in these exits. It dwells on the experience of various countries, including Chile, Colombia, Egypt, Israel, India, Poland, and Yemen. It begins by identifying conditions under which exits are sought. Next, it discusses the prerequisites for a successful exit, factors affecting the pace of exit, and the nature of the post‐exit regime. It then examines the behavior of private capital flows, interest rates, and official reserves before and after three successful exits (Chile, India, and Poland), and draws broad policy lessons.     

Too Big to Be Efficient? The Impact of Implicit Subsidies on Estimates of Scale Economies for Banks

We examine whether “too‐big‐to‐fail” (TBTF) factors affect estimates of scale economies for large banks. From a standard model of bank production that does not control for any TBTF factors, we find evidence of scale economies for our sample of large banks. We then control for TBTF factors by using a measure of the “implicit subsidy” that emerges from a reduction in TBTF banks’ funding costs due to investor expectations of government support. We do this in two ways: first, we estimate scale economies from an augmented model of bank production that employs a proxy for the counterfactual price of debt that banks would face in the absence of any TBTF funding cost advantage; second, we estimate scale economies from a model of bank production that is estimated only for a sample of banks considered unlikely to be TBTF. After controlling for TBTF factors using either method, we no longer find evidence of scale economies for our sample of large banks. These results suggest that estimated scale economies for large banks are affected by TBTF factors.