Optimal Mortgage Contract Choice Decision in the Presence of Pay Option Adjustable Rate Mortgage and the Balloon Mortgage

The unprecedented run-up in global house prices of the 2000s was preceded by a revolution in U.S. mortgage markets in which borrowers faced a plethora of mortgages to choose from collectively known as nontraditional mortgages (NTMs), whose poor performance helped ignite the global financial crisis in 2007. This paper studies the choice of mortgage contracts in an expanded framework where the menu of contracts includes the pay option adjustable rate mortgage (PO-ARM), and the balloon mortgage (BM), alongside the traditional long horizon fixed rate mortgage (FRM) and the short horizon regular ARM. The inclusion of the PO-ARM is based on the fact it is the most controversial and perhaps the riskiest of the NTMs, whereas the BM has not been analyzed in the literature despite its different risk-sharing arrangement and long vintage. Our inclusive model relates the structural differences of these contracts to the horizon risk management problems and affordability constraints faced by the households that differ in terms of expected mobility. The numerical solutions of the model generates a number of interesting results suggesting that households select mortgage contracts to match their horizon, manage horizon risk and mitigate liquidity or affordability constraints they face. From a risk management and welfare perspectives, we find that the optimal contract for households with shorter horizons, specifically households who expect to move house once every 1 to 2 years, is the PO-ARM. Beyond 2 years the welfare advantage of the PO-ARM diminishes and BM becomes the more optimal contract up to 5-year horizon. Overall, the results suggest that households are neither as risk averse as the selection of the FRM would suggest, nor are they as risk-seeking as the selection of PO-ARM or regular ARM would suggest. The results also suggest that the exuberance demonstrated for NTMs by borrowers, especially PO-ARMs, may be both rational and irrational.     

When are path-dependent payoffs suboptimal?

Generalizing a result by  and , this note shows that risk-averse investors with fixed planning horizon prefer path-independent payoffs in any financial market if the pricing kernel is a function of the underlying’s price at the end of the planning horizon. Generally, for every payoff which is not a function of the pricing kernel, there is a more attractive alternative that depends solely on the pricing kernel at the end of the planning horizon.     

Future generations: Economic, legal and institutional aspects

In economics, the issue of ‘future generations’ is mainly related to the environmental problems of resource consumption and pollution and their distribution over long time horizons. This paper critically discusses fundamental concepts in economics, such as efficiency and optimality, in relation to the incorporation of future generations in present day decision-making. Cost-benefit analysis (CBA) and discounting are used as a starting point and criticized for its inherent flaws such as incommensurability of values and its tendency to hide rather than reveal underlying values which are assumed to be fixed. We then investigate alternative approaches, in which, unlike in CBA, the preferences are not assumed to be a priori but must be constructed. Thus, interest groups or individuals must sit down together and figure out what things seem to be worth. The aim is to involve all interested parties in planning for the future.Similarly, on a national and regional level, increasingly stakeholder processes, deliberative and interest group procedures are used to develop strategies and visions for resource management and conservation. A similar case can be made for institutions at the international level. The legal examples provided in this paper show that rather than only installing an institution such as the guardian for the future on the global level, more ‘democratized’ bottom up approaches might be more appropriate.     

Managerial risk taking incentives and corporate pension policy

We examine whether the compensation incentives of top management affect the extent of risk shifting versus risk management behavior in pension plans. We find that risk shifting through pension underfunding (and, to a lesser extent, through pension asset allocation to risky securities) is stronger with compensation structures that create high wealth-risk sensitivity (vega) and weaker with high wealth-price sensitivity (delta). These findings are stronger for chief financial officers (CFOs) than for chief executive officers (CEOs), suggesting that pension policy falls within the CFO’s domain. Risk shifting through pension underfunding is also lower when the CFO’s personal stake in the pension plan is larger. Overall, these findings show that top managers’ compensation structure is an important driver of corporate pension policy. They also highlight firms within which the moral hazard concerns fueled by Pension Benefit Guaranty Corporation insurance are most relevant.     

Does freezing a defined benefit pension plan affect firm risk?

This paper examines the impact of a defined benefit (DB) pension plan freeze on the sponsoring firm's risk and risk-taking activities. Using a sample of firms declaring a hard freeze on their DB plans between 2002 and 2007, we observe an increase in total risk (proxied by the standard deviation of EBITDA and asset beta), equity risk (standard deviation of returns), and credit risk following a DB-plan freeze. The increase in credit risk is reflected in a decline in credit ratings and an increase in bond yields for freezing firms. When we examine investment strategies, we observe a shift in investment from capital expenditures before the freeze to more-risky R&D projects after the freeze, and an increase in leverage. These strategies (increased focus on R&D and higher leverage) increase the operating and financial risk the firm faces. Overall, we observe an increase in risk-taking following DB plan freezes, consistent with theories that DB plans act as “inside debt” that aligns managers’ interests with bondholders’.     

Audit committee equity holdings,the risk of reporting problems,and the achievement of earnings thresholds

There is conflicting evidence on whether audit committee equity holdings enhance or undermine committee effectiveness. Some researchers contend that equity holdings motivate audit committees to minimize the risk of reporting problems, while others believe equity holdings align the committees’ incentives with management. To reconcile these seemingly contradictory positions, I hypothesize that the influence of audit committee equity holdings depends upon the risk of reporting problems. I contend that when the risk of reporting problems is low (high) equity holdings motivate audit committees to give managers greater (less) discretion over reporting policies because the expected benefits from giving the discretion is greater (less) than the expected cost of the reporting problems that might occur from giving the discretion. I test whether the influence of audit committee equity holdings varies with the risk of reporting problems using a sample of 1370 firm-observations with earnings near the prior year’s earning level and a sample of 2389 firm-observations near analyst forecasts. I find the influence of audit committee equity holdings on the likelihood that a firm meets the prior year’s earnings level varies with the CEO’s equity incentives and the level of high-risk assets. I also find the influence of audit committee equity holdings on the likelihood that a firm meets analysts’ forecast varies with the CEO’s equity incentives and the effectiveness of internal controls. Collectively, my results suggest equity holdings enhance audit committee effectiveness by increasing a committee’s responsiveness to risk factors.     

CAPM option pricing

This paper extends the option pricing equations of [Black and Scholes, 1973] , [Jarrow and Madan, 1997] and [Husmann and Stephan, 2007] . In particular, we show that the length of the individual planning horizon is a determinant of an option’s value. The derived pricing equations can be presented in terms of the Black and Scholes [1973. Journal of Political Economy 81, 637–654] option values which ensures an easy application in practice.     

Accounting as an affective technology: A study of circulation,agency and entrancement

This paper argues that accounting is an affective technology. We show how people’s feelings and emotions are constructed through accounting practices and templates. Much research in accounting and economics is based on rationality assumptions that suggest that people act after working through cost–benefit calculations. Information may be imperfect and our cognitive abilities constrained but such modes of calculation and economic reasoning are assumed to drive action. Whilst not setting aside the significance of rationality and intelligibility, this study illustrates that it is affect and passion alongside cognitive calculation that generate movement and action in organisational networks. An in-depth case study of a very large and well known global American corporation spanning 4 years illustrates how affect is engineered by corporate executives through accounting templates and targets. In local sites, periods of excitement and elation ensue but so do anxiety and sleepless nights as yet again, budgets are cut and stated targets rise. Productivity spreadsheets, planning pyramids and human resource programs all contribute to the circulation of affect in the global network as new identities (both individual and collective) are defined and underperforming employees managed out. The committed and devoted ‘Players’ of the organisation express love for the firm, tolerate inconsistent instructions and overlook what might (by outsiders) be conceived as breaches of trust. As such, they collaborate in their own entrancement. We conclude that accounting technologies play on people’s passions and emotions rather than purely on their intellectual and reasoning skills, and that it is this emotive edge to accounting that generates and sustains action in organisational networks.     

Optimal Hedging under Intertemporally Dependent Preferences

This paper examines optimal hedging behavior in a market where preferences for current consumption are partly determined by the consumer's past consumption history. The model considers an individual exposed to price risk, who allocates wealth between consumption and futures contracts over a (continuous-time) finite planning horizon. The speculative component of the hedge ratio is shown to be smaller and the consumption path smoother than in models where preferences are separable over time. Some comparative-static properties of the hedge ratio are also examined.     

Operationalization of space/time perspectives of individuals—Theory and empirical results from Turkey

The overall aim of the research is to provide an evaluation of differences in time and space perspectives of individuals in Turkey in order to understand the different approaches, perspectives or priorities that they may bring to futures studies.An empirical study aimed to collect information about the varying differences in time and space perspectives among participant individuals (undergraduate and PhD students at Yeditepe University and managers at Siemens-Turkey) and any other possible factors affecting the participants’ choices. Two sets of statements are generated representing the time and space perspectives of participants using the modified constructs found in the literature such as “Time Strata”, “Space-Time Graph”, and “Different Time Frames and Activities”.Our sample population of 185 individuals indicated a time horizon of 4.8 years and space horizon of 530 km. Majority of the sample population is observed to be concerned with issues that affect only their close environment over a short time period of “next week”, along with their larger geographical area as the “city”. A few of the sample population indicated to have a global perspective on time and space that can further reach into the future.Literature suggesting different individuals having different perspectives on time and space, depending on culture, past experience and the nature of the problems are instrumentalized in our study by relating it to the foresight tools and methodologies. Such varying perspectives may explain individuals/managers’ time and space horizon in which they think and act/execute.Based on the analysis of space/time preference of participant individuals, policy makers will benefit from incorporating the diversity of time and space dimensions into their strategic thought and national policy roadmaps.This exploratory study is comprised of the assessment of differing definitions and approaches to the future via individuals’ space and time perspectives. It aims to contribute to foresight methodologies and approaches, as well as bringing a significant impact on the quality and success of the national foresight project results.     

Enterprise Risk Management Through Strategic Allocation of Capital

This article presents a conceptual framework for operationalizing strategic enterprise risk management (ERM) in a general firm. We employ a risk‐constrained optimization approach to study the capital allocation decisions under ERM. Given the decision maker's risk appetite, the problem of holistically managing enterprise‐wide hazard, financial, operational, and real project risks is treated by maximizing the expected total return on capital, while trading off risks simultaneously in Value‐at‐Risk type of constraints. This approach explicitly quantifies the concepts of risk appetite and risk prioritization in light of the firm's default and financial distress avoidance reflected in its target credit rating. Our framework also allows the firm to consider a multiperiod planning horizon so that changing business environments can be accounted for. We illustrate the implementation of the framework through a numerical example. As an initial conceptual advancement, our formulation is capable of facilitating more general ERM modeling within a consistent strategic framework, where idiosyncratic variations of firms and different modeling assumptions can be accommodated. Managerial implications are also discussed.     

The world price of liquidity risk

This paper empirically tests the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005) on a global level. Consistent with the model, I find evidence that liquidity risks are priced independently of market risk in international financial markets. That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns. I also show that the US market is an important driving force of global liquidity risk. Furthermore, I find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments. The findings show that the systematic dimension of liquidity provides implications for international portfolio diversification.     

Does the forward premium puzzle disappear over the horizon?

This paper provides the first comprehensive study of the horizon effect in tests of the forward rate unbiasedness hypothesis. It estimates Fama regressions employing 1-month through to 10-year horizon data for the five most heavily traded US dollar currency pairs pre-crisis 1980–2006. In contrast with extant studies, it fully deals with the econometric problems of long horizon regressions by means of a novel heteroskedastic- and autocorrelation-consistent bootstrap. The regression results confirm a clear horizon effect in that the slope coefficient approaches unity as the forward contract maturity is extended. The puzzle disappears at the 3-year horizon and beyond for all currencies.     

Stress testing credit risk: The Great Depression scenario

By employing Moody’s corporate default and rating transition data spanning the last 90 years we explore how much capital banks should hold against their corporate loan portfolios to withstand historical stress scenarios. Specifically, we will focus on the worst case scenario over the observation period, the Great Depression. We find that migration risk and the length of the investment horizon are critical factors when determining bank capital needs in a crisis. We show that capital may need to rise more than three times when the horizon is increased from 1 year, as required by current and future regulation, to 3 years. Increases are still important but of a lower magnitude when migration risk is introduced in the analysis. Further, we find that the new bank capital requirements under the so-called Basel 3 agreement would enable banks to absorb Great Depression-style losses. But, such losses would dent regulatory capital considerably and far beyond the capital buffers that have been proposed to ensure that banks survive crisis periods without government support.     

Convergent synergies in the global market for corporate control

We investigate the informational role of the takeover premium as a forward looking price to expected synergies in the global market for corporate control. We find that premiums paid in the global market for corporate control are clustered in waves and driven to some extent by the US premium. International takeover premiums have become more responsive to US premiums as the globalization process evolved over time. Short-run divergent dynamics due to idiosyncratic or country-specific factors have become less severe, which suggests that expected synergies have become increasingly integrated in the global market for corporate control. Furthermore, we find that the region’s takeover premiums typically become more responsive to US takeover premiums when US economic conditions are relatively weak, when the US monetary policy is restrictive, when US credit risk is high, and when the region’s corporate governance (as measured by legal system quality and accounting quality) is high.     

Downside risk of international stock returns

This paper investigates the downside risk exposure of international stock returns in 14 major industrialized economies around the world. For the period 1975–2010, we find that differences in returns on value and growth portfolios can be rationalized by assets’ reagibilities to market’s downside shocks. International value stocks are particularly sensitive to market’s permanent downside shocks, while international growth stocks are particularly sensitive to market’s temporary downside shocks. In line with recent evidence for the US, risk associated with unfavorable changes in market’s cash-flow innovations carries a premium which is pervasive and statistically significant.     

Financing climate policies through climate bonds – A three stage model and empirics

The funding of climate mitigation and adaptation policies has become an essential issue in climate negotiations. Emissions trading schemes (ETS) and carbon tax policies are widely discussed as viable mitigation strategies, the revenue from which might then be used for adaptation efforts. In most current models, the burden of enacting mitigation and adaptation policies falls on current generations. This paper expands on a recent article by Sachs (2014) that proposes intertemporal burden sharing, suggesting that implementation of climate policies would represent a Pareto improving strategy for both current and future generations. In particular, this paper proposes that green bonds (also referred to as climate bonds) represent an immediately implementable opportunity to initiate Sachs’ plan; the issuance of green bonds could fund immediate investment in climate mitigation such that the debt might be repaid by the future generations, those who benefit most from reduced environmental damages. The Sachs model is a discrete time overlapping generations model which we generalize and turn into a continuous time version exhibiting three major stages. We solve this three phase model by using a new numerical procedure called NMPC that allows for finite horizon solutions and phase changes. We show that the issued bonds can be repaid and the debt is sustainable within a finite time horizon. We also study econometrically whether the current macroeconomic environment is conducive to successfully phasing in such climate bonds.     

Systemic risk contributions: A credit portfolio approach

We put forward a framework for measuring systemic risk and attributing it to individual banks. Systemic risk is coherently measured as the expected loss to depositors and investors when a systemic event occurs. The risk contributions are calculated so as to ensure a full risk allocation among institutions. Applying our methodology to a panel of 54–86 of the world’s major commercial banks for a 13-year time span with monthly frequency not only allows us to closely match the list of G-SIBs; we can also use individual risk contributions to compute bank-specific surcharges: systemic capital charges as well as countercyclical buffers. We therefore address both dimensions of systemic risk – cross-sectional and time-series – in a single integrated approach. As the analysis of risk drivers confirms, the main focus of macroprudential supervision should be on a solid capital base throughout the financial cycle and de-correlation of banks’ asset values.     

Does multinationality matter? Implications of operational hedging for the exchange risk exposure

An important issue in global corporate risk management is whether the multinationality of a firm matters in terms of its effect on exchange risk exposure. In this paper, we examine the exchange risk exposure of US firms during 1983–2006, comparing multinational and non-multinational firms and focusing on the role of operational hedging. Since MNCs and non-multinationals differ in size and other characteristics, we construct matched samples of MNCs and non-multinationals based on the propensity score method. We find that the multinationality in fact matters for a firm’s exchange exposure but not in the way usually presumed – the exchange risk exposures are actually smaller and less significant for MNCs than non-multinationals. The results are robust with respect to different samples and model specifications. There is evidence that operational hedging decreases a firm’s exchange risk exposure and increases its stock returns. The effective deployment of operational risk management strategies provides one reason why MNCs may have insignificant exchange risk exposure estimates.     

The effects of loan portfolio concentration on Brazilian banks’ return and risk

This paper tests whether diversification of the credit portfolio at the bank level leads to better performance and lower risk. We employ a new high frequency (monthly) panel data for the Brazilian banking system with information at the bank level for loans by economic sector. We find that loan portfolio concentration increases returns and also reduces default risk; the impact of concentration on bank’s return is decreasing on bank’s risk; there are significant size effects; foreign and state-owned banks seem to be less affected by the degree of diversification. An important additional finding is that there is an increasing concentration trend after the breakout of the recent international financial crisis, specially after the failure of Lehman Brothers.