Derivative securities and cash market stability

This study investigates the effect of introducing interest-rate futures and options on the price variances in related financial cash markets. Standard research approaches to this issue relate cash-price stability before the introduction of futures and options trading to cash-price stability after trading in the derivative security begins. However, controlling for the additional factors that may also effect cash markets is difficult. The approach employed here to deal with this obstacle is motivated by recent theoretical research relating cash and futures markets, but hitherto not operationalized to empirically test for a relationship between the markets. Varying-parameter models of (1) the demand for short-term Treasury securities, (2) the demand for large time-deposits, and (3) the supply of large time-deposits are specified such that changes in the parameters imply changes in the volatility of the cash price. These parameters are modelled as functions of the trading volume of interest-rate futures and options, thereby enabling a direct test of the hypothesis that trading volume in these derivative securities influences the behaviour of cash-market participants, and therefore, cash-price volatility. We find no convincing evidence that the level of activity in interest-rate futures and options has a significant effect on these cash markets.     

Investor sentiment,variance risk premium and delta-hedged gains

Delta-hedged gains are supposed to be negative and represent a volatility risk premium. Using a sample of Standard & Poor 500 index options from 2006 to 2009, this study documents two anomalies that cannot be explained by the volatility risk premium. First, delta-hedged gains are more negative for out-of-money options than for at-the-money options. Second, delta-hedged gains are significantly positive during financial crisis period. We propose a behavioural explanation in which both option prices and stock prices are affected by investor’s sentiment, but pessimistic sentiment has a greater impact on stock market than option market. This asymmetric response to pessimistic mood in turn affects the relative expensiveness of option prices.     

Randomized double auctions: gains from trade,trader roles,and price discovery

Experimental double-auction commodity markets are known to exhibit robust convergence to competitive equilibria under stable or cyclical supply and demand conditions, but little is known about their performance in truly random environments. We provide a comprehensive study of double auctions in a stochastic setting where the equilibrium prices, trading volumes and gains from trade are highly variable across periods, and with commodity traders who may buy or sell their goods depending on market conditions and their individual outcomes. We find that performance in this stochastic environment is sensitive to underlying market conditions. Efficiency is higher and convergence to the competitive equilibrium stronger when the potential gains from trade are high and when the equilibrium spans a wide range of quantities, implying a large number of marginal trades. Speculative re-trading is prevalent, especially among those who have little to gain under equilibrium pricing. Those with the largest expected gains typically earn far less than predicted, while those with little or no predicted earnings gain modestly from speculation, leading to some redistribution of gains from high to low expected earners. Excessive trading volumes are associated with negative efficiencies in markets with low gains from trade, but not in the high-gains markets, where zero-sum trading and re-trading appear to enforce efficiency and near-equilibrium pricing. Buyers earn more relative to their competitive equilibrium benchmark than sellers do. Introducing trader specialization leads to fewer trading errors and higher market efficiency, but it does not eliminate zero-sum trading and re-trading.

     

Rolling settlement and market liquidity

This paper investigates the impact on UK stock and option markets of the change from an account based settlement system to a rolling settlement procedure. Such a change increases the transaction costs of short-term margin traders, and is likely to impact on the liquidity of the underlying market, as well as trading in the options market. Evidence is presented that the settlement procedure does impact on the liquidity of the market. Further, we find that rolling settlement increased market liquidity, consistent with the exit of margin traders as a result of the increase in short selling costs. Associated with this increase in liquidity is a significant reduction in nonoptionable stock trading volume, implying that margin trading may have been more prevalent in stocks without options. Finally, it is shown that while trading in stock options increased, the volatilities implied from call and put option prices indicate that put options have become relatively more expensive. This reflects the change in demand induced by the new settlement procedure, especially in terms of the increase in short selling costs.     

An Experimental Investigation of Hard and Soft Price Ceilings in Emissions Permit Markets

Tradable emissions permits have been implemented to control pollution levels in various markets and represent a major component of legislative efforts to control greenhouse gas emissions. Because permits are supplied for a fixed level of pollution, allowing the market for permits to determine the price, price control mechanisms may be needed to protect firms from price spikes caused by fluctuations in the demand for permits. We test permit markets in an experimental laboratory setting to determine the effectiveness of several price control mechanisms, with special attention on the soft price ceiling. We focus on a static setting similar to some of the earliest experimental work focused on price ceilings. Results indicate that both permit supply adjustments and price ceilings (hard ceilings) effectively limit elevated prices in this setting. By contrast, reserve auctions to implement soft ceilings do not consistently control prices, especially when a minimum reserve permit price is applied. Furthermore, the grandfathering of permits allows permit sellers to realize significant welfare gains at the expense of buyers under a soft ceiling policy. Our results thus highlight several advantages of hard ceilings for controlling short term price increases.     

CHANGES IN WATER ALLOCATION MECHANISMS FOR CALIFORNIA AGRICULTURE

Existing institutions allocating water in California reflect prior appropriation water rights established when water was abundant. These allocation rules queue users and do not encourage water conservation. Increased water scarcity and growing valuation of water's environmental benefits are inducing a transition to water allocation mechanisms that increase water efficiency in agriculture. Transferable rights systems will lead to market-like water allocation, induce farmers to adopt water conservation technology, and may not face strong objection from senior water rights holders. One must weigh the efficiency gains associated with transition from water rights to water markets against the transaction costs associated with installing facilities that enable water exchange and trading .
Transition to water markets may preserve the agricultural sector's well-being while allowing the transfer of some water outside of agriculture—in particular, for environmental benefit. The cost of policies proposed to reduce agricultural water supply while encouraging water trading are inversely related to the extent of trading allowed. The more farmers trade water, the less costly reducing water supply is to agriculture. Policies reducing water supply to Central Valley Project contractors and allowing trading only among these contractors are much more expensive than are policies encouraging trading among all agricultural water users in California .     

Land rental markets and rural poverty dynamics in Northern Ethiopia: Panel data evidence using survival models

There is growing interest in understanding the links between land reforms, land markets, and poverty reduction in Africa. The study uses four‐wave panel data from the northern highlands of Ethiopia to assess the dynamics of rural poverty taking into account the status of participation of rural households in the land rental market. Applying both nonparametric (Kaplan–Meier estimator) and semi‐parametric survival models that control for duration dependence of poverty transition, results show participation and degree of participation on the supply side of the tenancy market (landlords) have highly significant and positive effect on the chances of escaping poverty while the same cannot be said about the demand side of the tenancy market (tenants). The empirical evidence also confirms that households headed by older and literate people have relatively larger exit rates from poverty as compared with households headed by younger and illiterate ones. Though transacting farmers may engage themselves in win–win rental arrangements by the time they join the tenancy market, results indicate that gains are unequal as those tenants who enter the markets from low economic leverage (were poor) are liable to face a lower margin of net gains, which may limit their ability to move out of poverty.     

Modeling regional labor markets in Germany: insights not only for German policy makers

This paper develops an econometric model for studying the structure of regional labor markets. We estimate the model for three representative Western German federal states. The simulation results of these heterogeneous states reveal substantial structural differences in the short as well as the long-run. These differences impact on labor demand and labor supply and, hence, call for investigating demand and supply of labor instead of merely the unemployment rate. The revealed commonalities and differences may help regional as well as national policy makers to formulate policies tailored at the specific needs of regional labor markets.     

Comparative evaluation of the cost of water in northern Malawi: from rural water wells to science education

Worldwide, improved sources of drinking water are still lacking for 663 million people. With Malawi as a case study, we aim to address the scarcity of data available to understand the full cost and options of drinking water at a regional level covering both urban and rural areas. We studied options in the northern region of Malawi under the following thematic areas: urban piped water, water wells, handpump spare part supply networks, household point-of-use water treatment, the cost of entering a water business and capacity building in science education. Primary locally sourced data were collected as well as secondary publically available data. Additionally, local markets were surveyed for spare part networks. This research has shown that when looking at water resource economics in northern Malawi, it is not a monopoly and options are available at a range of costs. The data challenge policy-makers to reach the last 10% of the population still lacking improved drinking water. This will require a combination of expansion of urban piped water infrastructure, new boreholes in rural areas, increased handpump functionality rates, scale-up of household drinking water point-of-use treatment and growth of local universities to train local experts within the sector.     

Gains From Price Rigidity

This paper shows that there are substantial gains from price rigidity in an imperfectly competitive economy. Firms can increase their profits by agreeing some markets as markets of long-term contracts, of which prices are determined in advance to other spot market prices. Although they determine prices non-cooperatively in both markets, the mutual commitment making some markets' prices predetermined induces a price–price spiral between firms, which results in substantial gains for both firms. These gains outweigh the cost of inflexibility arising from price rigidity even though demand fluctuation is large and marginal cost is increasing.
JEL Classification Numbers: E30, E32.     

Demand and cost impacts of the 2 mm technology program in the US motor-vehicle market

We assess the impact on demand and producers’ costs of a new technology implemented in the US auto industry, the 2 mm program. This is a fascinating case partially because of the unique collaboration among public agencies and a consortium of manufacturers and universities. Using a type of hedonic price model for demand, we show that the new technology was responsible for a short-lived increase in demand for vehicles produced by US automakers at increased producers’ costs. Firms that refused to participate in the consortium attained smaller net gains implementing the technology independently. Overall, our approach differs from that of previous analysts in that we (1) separate demand from supply, (2) employ a comprehensive vehicle database, spanning 1981–1998 data, including data on virtually all vehicle models sold in the USA, as well as data on plants’ and producers’ technology characteristics, and (3) rely on sales and production data rather than plant data. Also, we quantify the cost of not participating in the consortium.     

Options and sunspots in a simple monetary economy

Summary. We study sunspot immunity in a dynamic monetary economy in which consumers are allowed to trade put and call option contracts on the general price level. We define the concept of strong sunspot immunity to characterize economies that have no sunspot equilibria regardless of the number of extrinsic states and their probabilities of occurrence. We show that a small number of option contracts can make an economy strongly sunspot immune. In addition, we demonstrate how asset re-trading opportunities, and the associated capital gains and losses, reduce the number of options needed for this result to obtain. Received: August 13, 1996; revised version: January 20, 1997     

Housing investment in urban China

What explains the rapidly increasing housing investment demand in China? To address this question, we develop an analytical framework featuring how expected capital gains impact households' housing investment decisions when subject to financial constraints. Housing demand in China takes place not only through households' owning multiple houses, but also through their owning a larger primary living residence if they are constrained from buying multiple houses. We show that households are more likely to own multiple houses when expecting higher capital gains. As expected capital gain increases, the primary housing demand of those households who are constrained from owning multiple houses increases, while those owing multiple housing units invest in extra ones instead of improving primary housing. Our empirical findings, based on 2010 and 2011 household survey data, are consistent with our theoretical predictions. We also find that the marginal effect of expected capital gains is higher for wealthier households. This links the booming housing market to widening income inequality which is a typical growth pain in a developing country like China. As an extension, we apply the analysis to derive implications of the institutional features (such as purchasing restriction policy and the existence of subsidized housing) for China’s housing markets.     

Broad-based employee stock options grants and IPO firms

This paper examines the broad-based grant of employee stock options (ESOs) in the period following the Initial Public Offering (IPO). Stock option grants are used to reduce the negative effects of conflicts of interests associated with a firm's going public. The study documents that option grants can be seen as corporate governance instruments for a number of model specifications. Also, it is found that there is a robust relation between option grants and market and accounting returns, respectively. To the best of the authors' knowledge, no previous study has investigated the determinants of the grants of employee stock options in the post-IPO period to both upper-level and lower-level executives during a period of sixteen years. Because the cross-sectional data of this study amply encompasses more than a business cycle it is possible to examine the grants of ESOs across tight and soft labour markets. During the former type of labour market it appears that more options are granted. Also, the empirical results provide evidence that option grants are an increasing function of the employees’ benefits for the firm. Finally, the findings show that cash constrained firms appear to use employee stock option grants in place of cash compensation.     

Strategic use of futures and options by commodity processors

The impacts of input–output price relationships on end-users' demands for positions in futures and options are analyzed using a mean-variance portfolio model and applied to price risk management in the bread manufacturing industry. A production relationship was assumed between the input and resultant output, and correlation between the input and output prices were introduced into the portfolio model. The optimal hedge ratio can be either positive or negative depending upon the relationship between the input and output price standard deviation adjusted for production technology and input–output price correlation. Introduction of a call option into the portfolio (in addition to the futures) does not change the hedging demand for futures; however, the speculative component changes. The results show that the addition of input–output linear production and price correlation relationships would not justify a hedging role for options unless there is bias in the futures and/or options markets.     

Stability of supply function equilibria implications for daily versus hourly bids in a poolco market

We consider a supply function model of a poolco electricity market where demand varies significantly over a time horizon such as a day and also has a small responsiveness to price. Although there are equilibria yielding prices at peak that are close to Cournot prices, it is known that the wider the range of demand uncertainty the narrower the range of such supply function equilibria. Here we show that such equilibria are also typically unstable and consequently would be difficult to sustain in practice. This strengthens the results of Green and Newbery by ruling out many equilibria that have high prices. We demonstrate this result both theoretically under somewhat restrictive assumptions and also numerically using both a three-firm example system and a five-firm example system having generation capacity constraints. Hence, this reinforces the conclusion that the market outcome is significantly influenced by a requirement that offers into the poolco be consistent over the time horizon. This result contrasts with markets where bids can be changed on an hourly basis, where Cournot prices are possible outcomes. The stability analysis has important policy implications for the design of day-ahead electricity markets. The stability perspective also provides a narrowing of the equilibrium selection that strengthens empirical analysis.      

Option contracting in the California water market

Temporary water transfers, as achievable under option contracts, capture gains from trade that would go unrealized if only permanent transfers of water rights were possible. This paper develops a bilateral option contracting model for water which includes the possibility of conveyance losses and random delivery. Seller-optimal and socially optimal option contracts are characterized in terms of relevant base and strike prices, as well as contract volumes, from an ex-ante and an ex-post point of view. Lastly, welfare gains are estimated, and actual contract prices in California are compared to model-predicted prices.     

Self‐Fulfilling Early‐Contracting Rush*

In markets for entry‐level professionals, the insurance motive drives some participants to sign early contracts. The rush to early contracting can be self‐fulfilling, as both its effect on expectations about demand–supply balance in the subsequent spot market and the effect on it from changes in the demand–supply balance can be nonmonotone. Matching markets with more risk‐averse participants, a greater uncertainty regarding relative supply of positions, or a more polarized distribution of applicant qualities are more vulnerable to self‐fulfilling early‐contracting rushes. Employers can have a collective interest in preventing early offers to a few promising applicants from starting the rushes.     

Calibrating spatial models of trade

Empirical spatial models of trade that are based on a mathematical programming specification often exhibit a large discrepancy between the equilibrium solution and the observed demand, supply and levels of trade flows among countries. This discrepancy may be due to several causes. Assuming, however, that a trade model is not misspecified – in the sense that behavior of the economic agents involved in the specific commodity markets has been included in the study and that the relevant policy instruments have been properly taken into account – the cause of discrepancy may be traced either to imprecision of unit transaction costs or to imprecision in the measurement of the demand and supply functions' parameters, or both. Policy assessments based on this type of imprecise models are distorted. This paper presents a methodology for calibrating mathematical programming spatial trade models of increasing complexity, from the one-commodity case to a multi-commodity model with asymmetric slope matrices of demand and supply functions. The proposed calibration procedure identifies corrections of imperfectly measured parameters. The calibrated models generate solutions that exactly reproduce quantities produced and consumed in all countries, as well as trade flows among all pairs of countries, observed in a given base year. Such models may then serve as a springboard for assessing the impact of various policy changes on economic agents in the countries under study.     

Investment options and the business cycle

This paper extends [R. Mehra, E.C. Prescott, Recursive competitive equilibrium: The case of homogeneous households, Econometrica 48 (1980) 1365-1380] to a production economy with two capital goods. It is an RBC model in which each unit of investment requires a new idea, an ‘option.’ When options are scarce, new capital is harder to put in place and the value of old capital rises. Thus the stock market and Tobin's Q are negative indexes of intangibles. During a boom, Q rises gradually, as options are used up. Because investment represents an exercise of options, it has an intertemporal substitution tradeoff that is absent from the adjustment-cost model. Equilibrium may be efficient even without markets for knowledge; the stock market may suffice.