Asset pricing theory for two price economies

We show that nonlinearly discounted nonlinear martingales are related to no arbitrage in two price economies as linearly discounted martingales were related to no arbitrage in economies satisfying the law of one price. Furthermore, assuming risk acceptability requires a positive physical expectation, we demonstrate that expected rates of return on ask prices should be dominated by expected rates of return on bid prices. A preliminary investigation conducted here, supports this hypothesis. In general we observe that asset pricing theory in two price economies leads to asset pricing inequalities. A model incorporating both nonlinear discounting and nonlinear martingales is developed for the valuation of contingent claims in two price economies. Examples illustrate the interactions present between the severity of measure changes and their associated discount rates. As a consequence arbitrage free two price economies can involve unique discount curves and measure changes that are however specific to both the product being priced and the trade direction. Furthermore the developed valuation operators call into question the current practice of Debt Valuation Adjustments.     

Scale economies and input price elasticities in microfinance institutions

We evaluate the efficiency of microfinance institutions (MFIs) using a structural approach which also captures these institutions’ outreach and sustainability objectives. We estimate economies of scale and input price elasticities for lending-only and deposit-mobilizing MFIs using a large sample of high-quality panel data. The results confirm conjectures that improvements in efficiency can come from the growth or consolidations of MFIs, as we find substantial increasing returns to scale for all but profitability-focused deposit-mobilizing MFIs. Our results support the existence of a trade-off between outreach and sustainability. All inputs are inelastic substitutes, but we find differences in own-price elasticities in lending-only and deposit-mobilizing MFIs.     

On a continuous time stock price model with regime switching,delay, and threshold

Motivated by the need to describe bear-bull market regime switching in stock prices, we introduce and study a stochastic process in continuous time with two regimes, threshold and delay, given by a stochastic differential equation. When the difference between the regimes is simply given by a different set of real valued parameters for the drift and diffusion coefficients, with changes between regimes depending only on these parameters, we show that if the delay is known there are consistent estimators for the threshold as long we know how to classify a given observation of the process as belonging to one of the two regimes. When the drift and diffusion coefficients are of geometric Brownian motion type we obtain a model with parameters that can be estimated in a satisfactory way, a model that allows differentiating regimes in some of the NYSE 21 stocks analyzed and also, that gives very satisfactory results when compared to the usual Black–Scholes model for pricing call options.     

Managing price and financial stability objectives in inflation targeting economies in Asia and the Pacific

Many central banks have adopted explicit objectives for financial stability, raising the possibility of trade-offs between price and financial stability objectives. Based on structural vector autoregressions that incorporate both monetary and macroprudential policy shocks for four inflation targeting economies in Asia and the Pacific, we analyse the role of each policy shock in explaining deviations from the other policy’s objective, by applying historical decompositions. The macroprudential measures used in the study affect credit extended to the private sector. We find that there are periods when macroprudential policy shocks have contributed to pushing inflation away from the central bank’s inflation target and when monetary policy shocks have contributed to buoyant credit, suggesting that there have been short-term trade-offs between price and financial stability objectives. However, we also find periods when macroprudential policy shocks helped stabilise inflation and monetary policy shocks contributed to financial stability.     

Robust reinsurance contracts in continuous time

We investigate reinsurance contract problems in a continuous-time principal-agent framework, where the reinsurer (principal) is concerned about potential model ambiguity in the claims process, but the insurer (agent) trusts the claims process, or vice versa. The reinsurer designs a robust reinsurance contract that maximizes his exponential utility of terminal wealth under the worst-case distribution, subject to the insurer’s incentive constraint. Optimal reinsurance contracts are explicitly derived in different ambiguity situations. We first show that the reinsurer’s robustness preference makes him become more conservative, which induces him to raise the reinsurance price, which then decreases the demand for reinsurance. However, the insurer’s robustness preference increases both the reinsurance price and the demand. Furthermore, the reinsurer continuously adjusts the reinsurance price, leading the insurer to always purchase a constant proportion of reinsurance, no matter who faces ambiguity, or whether ambiguity exists. Finally, the economic implications of model ambiguity are illustrated using numerical examples.     

Completion time structures of stock price movements

Summary This paper proposes to model movements in more than a century of daily US stock prices as the outcome of a multi-state marked point process and studies the time it takes for stock prices to complete an up or a down move of a certain size. We present a new econometric specification for a class of dynamic models that account for autoregressive conditional duration effects. We also present a method to account for the effect of time-varying state variables that may change within a duration.We find strong evidence of dynamic dependencies in the direction and speed of stock price movements. Past interest rates are also found to affect the speed and direction of completion times. Out-of-sample prediction results show that forecasts of the direction of moves in stock prices can be greatly improved by including covariates such as interest rates and allowing for dynamics in the econometric specification.We thank an anonymous referee, an associate editor, Rob Engle, Mark Machina and Ruth Williams for helpful conversations. We are grateful to INQUIRE UK for financial support for this research.     

Duality for pathwise superhedging in continuous time

Finance and Stochastics - We provide a model-free pricing–hedging duality in continuous time. For a frictionless market consisting of $d$  risky assets with continuous price...     

On time-inconsistent stochastic control in continuous time

In this paper, which is a continuation of the discrete-time paper (Björk and Murgoci in Finance Stoch. 18:545–592, 2004), we study a class of continuous-time stochastic control problems which, in various ways, are time-inconsistent in the sense that they do not admit a Bellman optimality principle. We study these problems within a game-theoretic framework, and we look for Nash subgame perfect equilibrium points. For a general controlled continuous-time Markov process and a fairly general objective functional, we derive an extension of the standard Hamilton–Jacobi–Bellman equation, in the form of a system of nonlinear equations, for the determination of the equilibrium strategy as well as the equilibrium value function. The main theoretical result is a verification theorem. As an application of the general theory, we study a time-inconsistent linear-quadratic regulator. We also present a study of time-inconsistency within the framework of a general equilibrium production economy of Cox–Ingersoll–Ross type (Cox et al. in Econometrica 53:363–384, 1985).     

Cointegration test of oil price and us dollar exchange rates for some oil dependent economies

This study examines the long-run dynamics between oil price and the bilateral US dollar exchange rates for a group of oil-dependent economies before and after the 2008–2009 Global Financial Crises. Exchange rates are for the euro, Indian rupee, Russian ruble, South African rand, Ghanaian cedi and the Nigerian naira. The dependence on crude oil of these economies is either because fiscal revenues are primarily reliant on oil export receipts or because industrial production is heavily dependent on petroleum. Empirical results show evidence of a long run equilibrium relationship between oil price and exchange rate, especially for currencies of the key oil-exporting countries. This relationship is more evident in the post crisis period, which is also the period when both exchange rate volatility and the inverse relationship between oil price and exchange rate experienced a significant increase.     

Winter blues and time variation in the price of risk

Previous research has documented robust links between seasonal variation in length of day, seasonal depression (known as seasonal affective disorder, or SAD), risk aversion, and stock market returns. The influence of SAD on market returns, known as the SAD effect, is large. We study the SAD effect in the context of an equilibrium asset pricing model to determine whether the seasonality can be explained using a conditional version of the CAPM that allows the price of risk to vary over time. Using daily and monthly data for the US, Sweden, New Zealand, the UK, Japan, and Australia, we find that a conditional CAPM that allows the price of risk to vary in relation to seasonal variation in the length of day fully captures the SAD effect. This is consistent with the notion that the SAD effect arises due to the heightened risk aversion that comes with seasonal depression, reflected by a changing risk premium.     

Stylised facts of financial time series and hidden Markov models in continuous time

Hidden Markov models are often applied in quantitative finance to capture the stylised facts of financial returns. They are usually discrete-time models and the number of states rarely exceeds two because of the quadratic increase in the number of parameters with the number of states. This paper presents an extension to continuous time where it is possible to increase the number of states with a linear rather than quadratic growth in the number of parameters. The possibility of increasing the number of states leads to a better fit to both the distributional and temporal properties of daily returns.     

Speculative attacks: A laboratory study in continuous time

We examine speculative attacks in a controlled laboratory environment featuring continuous time, size asymmetries, and varying amounts of public information. Attacks succeeded in 233 of 344 possible cases. When speculators have symmetric size and access to information: (a) weaker fundamentals increase the likelihood of successful speculative attacks and hasten their onset, and (b) contrary to some theory, success is enhanced by public access to information about either the net speculative position or the fundamentals. The presence of a larger speculator further enhances success, and experience with large speculators increases small speculators' response to the public information. However, giving the large speculator increased size or better information does not significantly strengthen his impact.     

Two targets,two instruments: Monetary and exchange rate policies in emerging market economies

This paper examines the case for using two instruments—the policy interest rate and sterilized foreign exchange market intervention—in emerging market countries seeking to stabilize inflation and output while attenuating disequilibrium currency movements. We estimate policy reaction functions for central banks, documenting that indeed both instruments tend to be deployed. We show that whether discretionary monetary policy or inflation targeting is preferable depends on the volatility of shocks relative to the central bank's time inconsistency problem. The use of FX intervention as a second instrument improves welfare under both regimes, but more so under inflation targeting. Overall, a regime of (two-way) sterilized intervention-cum-inflation targeting can result in better outcomes in the presence of imperfect capital mobility/asset substitutability—yielding similar gains to a discretionary policy while still delivering the inflation target.     

National price levels, purchasing power parity, and cointegration: a test of four high inflation economies

The time series properties of exchange rates and wholesale prices from four high inflation countries show some evidence in support of purchasing power parity. Tests for stationarity of real exchange rates and cointegration among price and exchange rate variables are presented for Argentina, Brazil, Chile, and Israel during the 1970s and 1980s. Error correction models describe the mechanism of adjustment to long-run equilibrium.     

Forecasting stock-market tail risk and connectedness in advanced economies over a century: The role of gold-to-silver and gold-to-platinum price ratios

We examine the predictive value of risk perceptions as measured in terms of the gold-to-silver and gold-to-platinum price ratios for stock-market tail risks and their connectedness in eight major industrialized economies using monthly data for the period 1916:02–2020:10 and 1968:01–2020:10, where we use four variants of the popular Conditional Autoregressive Value at Risk (CAViaR) framework to estimate the tail risks for both 1% and 5% VaRs. Our findings for the short sample period show that the gold-to-silver price ratio resembles the gold-to-platinum price ratios in that it is a useful proxy for global risk. Our findings for the long sample period show, despite some heterogeneity across economies, that the gold-to-silver price ratio often helps to out-of-sample forecast for both 1% and 5% stock market tail risks, particularly when a forecaster suffers a higher loss from underestimation of tail risks than from a corresponding overestimation of the same absolute size. We also find that using the gold-to-silver price ratio for forecasting the total connectedness of stock markets is beneficial for an investor who suffers a higher loss from an underestimation of total connectedness (i.e., an investor who otherwise would overestimate the benefits from portfolio diversification) than from a comparable overestimation.     

Innovation capacities in advanced economies: Relative performance of small open economies

This paper offers an empirical examination of the determinants of a nation's ability to produce commercially viable innovations, measured as Patents Granted across a sample of 23 advanced economies. The approach employed is based on estimating National Innovative Capacity that focuses on the long-run ability of economies to produce and/or commercialise innovative technologies, in the spirit of Furman et al. (2002). The time period of our analysis covers 1993 to 2005 and employs panel estimation.Motivated by differences in the rate of innovation between economies with different economic structures we examine the Small Open Economies (SOEs) in our country sample to assess whether there is a significant difference between the determinants of Innovative Capacity in SOEs and the other larger developed economies.We find that advanced SOEs and larger economies do not differ substantially in their determinants of producing innovative technologies and, notwithstanding the limitations of Patents as measures of innovative activity, we conclude that policy choice and variation plays a key role in determining the productivity of R&D, when measured as patenting activity.     

Crowding out in Ricardian economies

The crowding-out coefficient is the ratio of the reduction in privately-issued bonds to the increase in government bonds that are issued to finance a tax cut. If (1) Ricardian Equivalence holds, and (2) households do not borrow risklessly while holding positive gross positions in other riskless assets, the crowding-out coefficient equals the fraction of the aggregate tax cut that accrues to households that borrow. In the conventional case in which all households receive equal tax cuts, the crowding-out coefficient equals the fraction of households that borrow; in the United States, about 75% of households borrow, so the crowding-out coefficient is predicted to be 0.75. Allowing for cross-sectional variation in tax changes increases the crowding-out coefficient to about 0.85.     

A continuous time approach to the pricing of bonds

This paper develops an arbitrage model of the term structure of interest rates based on the assumptions that the whole term structure at any point in time may be expressed as a function of the yields on the longest and shortest maturity default free instruments and that these two yields follow a Gauss-Wiener process. Arbitrage arguments are used to derive a partial differential equation which must be satisfied by the values of all default free bonds. The joint stochastic process for the two yields is estimated using Canadian data and the model is used to price a sample of Government of Canada bonds.