Bond Pricing with a Time‐Varying Price of Risk in an Estimated Medium‐Scale Bayesian DSGE Model

New Keynesian model in which households have Epstein–Zin preferences with time‐varying risk aversion and the central bank has a time‐varying inflation target can match the dynamics of nominal bond prices in the U.S. economy well. The model generates a large steady‐state term spread and its fitting errors for bond yields are comparable to those obtained from a nonstructural three‐factor model, and one‐third smaller than in models with a constant inflation target or risk aversion. Including data on interest rates has large effects on variance decompositions, making investment technology shocks much less important than found in other recent papers.     

The Relationship between Multiple Choice and Essay Response Questions in Assessing Economics Understanding

Efficiency considerations have led to increased use of multiple-choice questions to assess economics understanding at the secondary and tertiary levels throughout Australia. A multiple-choice test would suffice if multiple-choice and essay questions measure the same dimensions of knowledge, as suggested by least squares estimation of the relationship between these two forms of testing. We show a simultaneous equation bias inherent in least squares estimation of the relationship between these two forms. A two-stage least squares estimation reveals no relationship, implying that these testing forms measure different dimensions of knowledge. Thus, a single form of testing economics knowledge must be avoided.     

The Effect of Audit Quality on Earnings Management*

This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non-Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross-sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non-Big Six firm years. Specifically, clients of non-Big Six auditors report discretionary accruals that are, on average, 1.5-2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non-Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.     

The Intertemporal Relation Between the U.S. and Japanese Stock Markets

This paper finds a high correlation between the open to close returns for U.S. stocks in the previous trading day and the Japanese equity market performance in the current period. In contrast, the Japanese market has only a small impact on the U.S. return in the current period. High correlations among open to close returns are a violation of the efficient market hypothesis; however, in trading simulations, the excess profits in Japan vanish when transactions costs and transfer taxes are included.     

Methodological Issues in Cross-Sectional and Panel Estimates of the Human Resource-Firm Performance Link

Because companies differ in factors such as management ability that may lead to both high performance work systems and enhanced firm performance, conventional estimates of the effects of human resource (HR) management practices on firm performance may be biased upward. Alternatively, if HR management practices are measured with error, estimates of their effects on firm performance may be biased downward. We find that although longitudinal estimates that avoid the first source of bias are substantially smaller than cross-sectional estimates, the former are strongly influenced by errors in measuring HR management practices. Based on independent estimates of the measurement error, we calculate a range of estimates that correct for both biases. We estimate that a one standard deviation increase in our measure of high performance work systems raises the market value of the corporation by approximately $15,000 per employee.     

Bad Times,Good Credit

Banks’ limited knowledge about borrowers’ creditworthiness constitutes an important friction in credit markets. Is this friction deeper in recessions, thereby contributing to cyclical swings in credit, or is the friction reduced, as bad times reveal information about firm quality? We test these alternative hypotheses using internal ratings data from a large Swedish cross-border bank and credit scores from a credit bureau. The ability to classify corporate borrowers by credit quality is greater during bad times and worse during good times. Soft and hard information measures both display countercyclical patterns. Our results suggest that information frictions in corporate credit markets are intrinsically countercyclical and not due to cyclical variation in monitoring effort. The presence of countercyclical information frictions provides a rationale for countercyclical provisions or capital in banks to smooth credit cycles.     

Reaching for Yield in the Bond Market

This paper studies reaching for yield—investors’ propensity to buy riskier assets to achieve higher yields—in the corporate bond market. We show that insurance companies reach for yield in choosing their investments. Consistent with lower rated bonds bearing higher capital requirements, insurance firms prefer to hold higher rated bonds. However, conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. This behavior is related to the business cycle being most pronounced during economic expansions. It is also characteristic of firms with poor corporate governance and for which the regulatory capital requirement is more binding.