A note on asset management and market risk

The textbook view on risk in asset management companies is summarized by Hull (Risk Management and Financial Institutions, p. 372, 2007): “For an asset manager the greatest risk is operational risk.” Using evidence from various panel regression models, we show that asset management revenues carry substantial market risks, a finding that challenges not only academic risk management literature on the predominance of operative risks, but also the current industry practice of not hedging market risks that are systematically built into the revenue-generation process. For asset management companies to return to an annuity model, these risks need to be managed more actively. Shareholders do not want to be exposed to market beta by investing in asset management companies; they want to participate in these companies’ alpha generation and take advantage of their fund-gathering expertise as financial intermediaries.     

Balance,growth and diversity of financial markets

A financial market comprising of a certain number of distinct companies is considered, and the following statement is proved: either a specific agent will surely beat the whole market unconditionally in the long run, or (and this “or” is not exclusive) all the capital of the market will accumulate in one company. Thus, absence of any “free unbounded lunches relative to the total capital” opportunities lead to the most dramatic failure of diversity in the market: one company takes over all other until the end of time. In order to prove this, we introduce the notion of perfectly balanced markets, which is an equilibrium state in which the relative capitalization of each company is a martingale under the physical probability. Then, the weaker notion of balanced markets is discussed where the martingale property of the relative capitalizations holds only approximately, we show how these concepts relate to growth-optimality and efficiency of the market, as well as how we can infer a shadow interest rate that is implied in the economy in the absence of a bank.      

The marginal cost of public funds and the flypaper effect

A lump-sum intergovernmental transfer has a “price effect”, as well as an “income effect”, because it allows the recipient government to reduce its tax rate, which lowers its marginal cost of public funds, while still providing the same level of public service. This reduction in the effective price of providing the public service helps to explain the “flypaper effect”—the empirical observation that a lump-sum grant has a much larger effect on spending than an increase in personal income. Contrary to the assertions of Mieszkowski (Modern Public Finance, 1994) and Hines and Thaler (J. Econ. Perspect. 9:217–226, 1995), a model of a benevolent local government financing its expenditures with a distortionary tax predicts flypaper effects from lump-sum grants that are similar to those observed in many econometric studies.     

Non-parametric method for European option bounds

There is much research whose efforts have been devoted to discovering the distributional defects in the Black–Scholes model, which are known to cause severe biases. However, with a free specification for the distribution, one can only find upper and lower bounds for option prices. In this paper, we derive a new non-parametric lower bound and provide an alternative interpretation of Ritchken’s (J Finance 40:1219–1233, 1985) upper bound to the price of the European option. In a series of numerical examples, our new lower bound is substantially tighter than previous lower bounds. This is prevalent especially for out of the money options where the previous lower bounds perform badly. Moreover, we present how our bounds can be derived from histograms which are completely non-parametric in an empirical study. We discover violations in our lower bound and show that those violations present arbitrage profits. In particular, our empirical results show that out of the money calls are substantially overpriced (violate the lower bound).     

Evidence of the invisible: toward a credibility revolution in the empirical analysis of tax evasion and the informal economy

Empirical research about tax evasion and the informal economy has exploded in the past few decades, seeking to shed light on the magnitude and (especially policy) determinants of these phenomena. Quantitative information informs the analysis of policy choices, enables the testing of hypotheses about determinants of this phenomenon, and can help with the accurate construction of national income accounts. Even as empirical analysis has burgeoned, some have expressed doubts about the quality and usefulness of some prominent measures. The fact that high-quality data is elusive is neither surprising nor a coincidence. The defining characteristic of tax evasion and informal economic activity—that they are generally illegal—often renders unreliable standard data collection methods such as surveys. Unlike invisible phenomena in the natural sciences, these invisible social science phenomena are hard to measure because of choices made by individuals. Analysis of tax evasion and the informal economy must proceed even in the absence of the direct observability of key variables, and theory should guide the construction and interpretation of evidence of the “invisible.” In this paper, we address what can be learned using micro or macro data regarding tax evasion and the informal economy under given conditions and assumptions, and critically review some of the most common empirical methods in light of our conclusions. We conclude with an entreaty for researchers in this field to enlist in the “credibility revolution” (Angrist and Pischke in J. Econ. Perspect. 4(2):3–30, 2010) in applied econometrics.     

The makings of an information leader: the intraday price discovery process for individual stocks in the DJIA

The main purpose of this paper is to construct an intraday arbitrage price series for each stock in the DJIA using information in the Diamond Trust Fund ETF. We then compute the information shares (Hasbrouck in J Finan 50(4):1175–1199, 1995) for the actual versus the arbitrage prices for each stock. While previous literature documents that ETFs lead stock indices in information origination, we find that some firms are “information leaders” in that the information share that comes from the stock price is larger than that which comes from the ETF-related arbitrage price. Further analysis is conducted to uncover the firm-specific factors that are related to a stock’s role in information generation.     

On the optimal use of loose monitoring in agencies

We study the governance implications of firms being privately informed of their potential productivity before contracting with an agent to supply unobservable effort. We show that it can be optimal for high potential firms to have “loose monitoring” in the sense that the monitoring system is less perfect than what is implied by a standard agency model a la Holmstrom (The Bell J Econ 10:74–91, 1979). Loose monitoring is used to achieve separation among different types of firms such that firms with low potential do not have incentives to imitate contracts offered by high potential firms. Our findings imply that although loose monitoring may be a symptom of firms squandering scarce resources provided by investors, it can also arise as an optimal contracting arrangement.     

Preference heterogeneity and asset prices: An exact solution

We introduce a general equilibrium model of a multi-agent, pure-exchange economy and find a set of conditions that enable us to obtain explicit closed-form solutions to the equilibrium interest rate, stock price, risk premium and stock market volatility when investors have heterogenous risk aversions. Because the market is dynamically complete, full risk sharing obtains and a representative agent can be constructed, though the risk aversion of this agent fluctuates over time with the state of the economy, as the relative wealth distribution of the individual investors changes. We show that preference heterogeneity can cause asset prices to be significantly more volatile than the underlying dividends and that it can lead to leverage-like effects in volatility, in the sense that volatility increases after stock-market declines.     

Mortgage Put Options and Real Estate Markets

In this paper we offer direct evidence that financial intermediation does impact underlying asset markets. We develop a specific observable symptom of a banking system that underprices the put option imbedded in non-recourse asset-backed lending. Using a dataset for 19 countries and over 500 real estate investment trusts, we find that, following a negative demand shock, the “underpricing” economies experience far deeper asset market crashes than economies in which the put option is correctly priced.

Risk-neutral compatibility with option prices

A common problem is to choose a “risk-neutral” measure in an incomplete market in asset pricing models. We show in this paper that in some circumstances it is possible to choose a unique “equivalent local martingale measure” by completing the market with option prices. We do this by modeling the behavior of the stock price X, together with the behavior of the option prices for a relevant family of options which are (or can theoretically be) effectively traded. In doing so, we need to ensure a kind of “compatibility” between X and the prices of our options, and this poses some significant mathematical difficulties.     

The value relevance of corporate restructuring charges

We document in this study that investors react positively to restructuring that is expected to be successful in improving firm performance. Investors’ reaction is significantly negative to unsuccessful firms when the magnitude of restructuring charges is high. Our results also show that investors’ reaction is significantly positive to restructuring that is intended to save costs through “workforce reduction” and “facility closings/consolidations”, but it is insignificant when restructuring is undertaken to recognize decline in asset values by asset write-offs and/or write-downs. Investor reaction is measured by 12-month buy-and-hold abnormal returns, whereas successful restructuring to improve the firm performance is based on the change in operating performance, measured by the industry-adjusted return on equity (ROE), over two subsequent years after restructuring.

Asset price bubbles from heterogeneous beliefs about mean reversion rates

Harrison and Kreps showed in 1978 how the heterogeneity of investor beliefs can drive speculation, leading the price of an asset to exceed its intrinsic value. By focusing on an extremely simple market model—a finite-state Markov chain—the analysis of Harrison and Kreps achieved great clarity but limited realism. Here we achieve similar clarity with greater realism, by considering an asset whose dividend rate is a mean-reverting stochastic process. Our investors agree on the volatility, but have different beliefs about the mean reversion rate. We determine the minimum equilibrium price explicitly; in addition, we characterize it as the unique classical solution of a certain linear differential equation. Our example shows, in a simple and transparent manner, how heterogeneous beliefs about the mean reversion rate can lead to everlasting speculation and a permanent “price bubble.”     

Disentangling the Short and Long-Run Effects of Occupied Stock in the Rental Adjustment Process

In the current stand of literature on the rental adjustment process starting with Hendershott et al. (Real Estate Economics, 30, 165-183, 2002a, Journal of Real Estate Finance and Economics, 24, 59-87, 2002b) it has become practice to treat the compound variable “occupied stock” as a supply variable. In this study we show that this variable deserves a more critical investigation and that the general view of a supply variable may be misleading. Using panel data covering 30 urban areas for 17 years, we investigate the rental adjustment process in the German office market. The application of recently developed cointegration techniques for non-stationary panel data in conjunction with the corresponding error correction model (ECM) enables us to overcome the data limitations, particularly existent for most European real estate markets. Hence, our primary motivation is (a) to demonstrate how “occupied stock” should be interpreted correctly and (b) to provide useful insights into the long-term relationships and short-run dynamics of real office prime rents. The empirical evidence suggests that a one percent rise in office employment increases real rents on average by 1.64% through higher demand for office space. On the other hand, a one percent increase in the supply of office space decreases real rents in the long run by 2.25%. The results from the error correction model show that deviations from the long-run equilibrium lead to an adjustment process which restores equilibrium within approximately 3 years.     

Is information risk priced for NASDAQ-listed stocks?

Easley et al. (J Finance 57:2185–2221, 2002), building upon the asset pricing model of Fama and French (J Finance 47:427–465, 1992), show that the probability of informed trading (PIN) is a determinant of asset returns for NYSE-listed securities. We extend this work by examining whether the PIN is a predictive factor for NASDAQ stocks, as many studies document significant differences between NYSE and NASDAQ listed securities. In the process we examine whether the use of PIN is appropriate for NASDAQ-listed securities. We find that PIN and certain stock characteristics correlate differently for our sample of NASDAQ stocks than that of Easley et al. sample of NYSE stocks. We also determine that the risk of informed trading is only weakly priced for NASDAQ stocks. Contrary to Easley et al. we do not find evidence that excess returns increases as PIN increases.     

Public Investment Criteria in Overlapping Generations Models of Open Economies

This paper derives criteria for worthwhile public investment in an overlapping generations model of an “almost small” open economy- an economy with access to external funding at a given interest rate, but with some influence over its temporal terms of trade. If the economy is dynamically efficient (i.e. the interest rate exceeds the growth rate), committed to free trade, public investment is debt financed and lump sum taxes are feasible, two results follow. First, the “social opportunity cost of public funds” will exceed the government's borrowing rate because of the adverse effect of government borrowing on the terms of trade. Second, the marginal rate of return on worthwhile public investment will be greater than the social opportunity cost of public funds if public and private investment are complements (substitutes) and the tax on capital is below (above) the rate that minimizes the steady state burden of servicing the debt. JEL Code: F21, H43     

Structural Breaks and the Convergence of Regional House Prices

This paper differs from past research by examining the issue of whether regime changes have broken down the stability of the ripple effect. The endogenous two-break LM unit test, derived in Lee and Strazicich (Review of Economics and Statistics 85: 1082–1089, 2003), is used to execute the ripple effect tests. Being different from the empirical results of the conventional unit root tests without structural breaks, the empirical results of the endogenous two-break LM unit root test support the existence of ripple effects for each city in Taiwan except Taipei City. Shocks to regional house prices of Taipei City cannot “ripple out” across the nation, because Taipei City is a regional global city which has resulted in higher house prices, but does not affect the house prices of the entire area. Furthermore, the empirical evidence demonstrates the breakpoints and presents real estate policies, financial crises, and natural disease that can cause structural breaks of regional house prices.     

Pricing growth-rate risk

We characterize the compensation demanded by investors in equilibrium for incremental exposure to growth-rate risk. Given an underlying Markov diffusion that governs the state variables in the economy, the economic model implies a stochastic discount factor process S. We also consider a reference growth process G that may represent the growth in the payoff of a single asset or of the macroeconomy. Both S and G are modeled conveniently as multiplicative functionals of a multidimensional Brownian motion. We consider the pricing implications of parametrized family of growth processes G ^ε , with G ⁰=G, as ε is made small. This parametrization defines a direction of growth-rate risk exposure that is priced using the stochastic discount factor S. By changing the investment horizon, we trace a term structure of risk prices that shows how the valuation of risky cash flows depends on the investment horizon. Using methods of Hansen and Scheinkman (Econometrica 77:177–234, 2009), we characterize the limiting behavior of the risk prices as the investment horizon is made arbitrarily long.     

Two-Sided Bounds for Ruin Probabilities when the Adjustment Coefficient does not Exist

In this paper, we derive two-sided bounds for the ruin probability in the compound Poisson risk model when the adjustment coefficient of the individual claim size distribution does not exist. These bounds also apply directly to the tails of compound geometric distributions. The upper bound is tighter than that of Dickson (1994). The corresponding lower bound, which holds under the same conditions, is tighter than that of De Vylder and Goovaerts (1984). Even when the adjustment coefficient exists, the upper bound is, in some cases, tighter than Lundberg's bound. These bounds are applicable for any positive distribution function with a finite mean. Examples are given and numerical comparisons with asymptotic formulae for the ruin probability are also considered.