Evaluating the Technical Provisions for Traditional Brazilian Annuity Plans: Continuous-Time Stochastic Approach Based on Solvency Principles

This article presents an approach for evaluating the liabilities of traditional Brazilian annuity plans, using a continuous-time stochastic approach based on modern solvency principles. The technical provisions are obtained by means of conditional expectation, under a real-world measure and considering the peculiar characteristics of each plan and the financial guarantees and profit participations (bonus and dividend plans) embedded in the annuity plans. We assume that policyholder behavior is not optimal, but we also illustrate a calculation of provision assuming optimal policyholder behavior to show the differences between both assumptions. In this article all explicit provisions formulas are derived, and several relevant conclusions about the values of these provisions are discussed.     

Forbearance and Prompt Corrective Action

This article investigates whether a bank regulator should terminate problem banks promptly or exercise forbearance. We construct a dynamic model economy in which entrepreneurs pledge collateral, borrow from banks, and invest in long-term projects. We assume that collateral value has aggregate risk over time, that in any period entrepreneurs can abscond with the projects but lose the collateral, and that depositors can withdraw deposits. We show that optimal regulation exhibits forbearance if the ex-ante probability of collapse in collateral value is sufficiently low, but exhibits prompt termination of problem banks if this probability is sufficiently high.     

Option pricing with random volatilities in complete markets

This article presents the theory of option pricing with random volatilities in complete markets. As such, it makes two contributions. First, the newly developed martingale measure technique is used to synthesize results dating from Merton (1973) through Eisenberg, (1985, 1987). This synthesis illustrates how Merton's formula, the CEV formula, and the Black-Scholes formula are special cases of the random volatility model derived herein. The impossibility of obtaining a self-financing trading strategy to duplicate an option in incomplete markets is demonstrated. This omission is important because option pricing models are often used for risk management, which requires the construction of synthetic options.Second, we derive a new formula, which is easy to interpret and easy to program, for pricing options given a random volatility. This formula (for a European call option) is seen to be a weighted average of Black-Scholes values, and is consistent with recent empirical studies finding evidence of mean-reversion in volatilities.Helpful comments from an anonymous referee are greatly appreciated.     

Revisiting the demand for money function: evidence from the random coefficients approach

This article employs second-generation random coefficient (RC) modeling to investigate the time-varying behavior and the predictability of the money demand function in Taiwan over the period from 1982Q1 to 2006Q4. The RC procedure deals with some of the limitations of previous studies, such as unknown functional forms, omitted variables, measurement errors, additive error terms, and the correlations between explanatory variables and their coefficients. Our main findings are as follows. First, the empirical results indicate that the values of the elasticities in the RC estimation are significantly different from those in other studies, because of the use of coefficient drivers. Second, by observing the time-varying behavior of the coefficients, we find some specific points in our time profile of coefficients; that is, we can make an association with real events occurring in Taiwan, such as the financial liberalization after 1989 and the Asian financial crisis of 1997–1998. Finally, we compare the predicted values via the time intervals and different specifications and find that we should adapt different specifications of the RC model to estimate each interval.     

Housing Price Dynamics in Time and Space: Predictability,Liquidity and Investor Returns

It is widely accepted that aggregate housing prices are predictable, but that excess returns to investors are precluded by the transactions costs of buying and selling property. We examine this issue using a unique data set—all private condominium transactions in Singapore during an eleven-year period. We model directly the price discovery process for individual dwellings. Our empirical results clearly reject a random walk in prices, supporting mean reversion in housing prices and diffusion of innovations over space. We find that, when house prices and aggregate returns are computed from models that erroneously assume a random walk and spatial independence, they are strongly autocorrelated. However, when they are calculated from the appropriate model, predictability in prices and in investment returns is completely absent. We show that this is due to the illiquid nature of housing transactions. We also conduct extensive simulations, over different time horizons and with different investment rules, testing whether better information on housing price dynamics leads to superior investment performance.     

The Conditional CAPM and the Cross-Section of Expected Returns

Most empirical studies of the static CAPM assume that betas remain constant over time and that the return on the value-weighted portfolio of all stocks is a proxy for the return on aggregate wealth. The general consensus is that the static CAPM is unable to explain satisfactorily the cross-section of average returns on stocks. We assume that the CAPM holds in a conditional sense, i.e., betas and the market risk premium vary over time. We include the return on human capital when measuring the return on aggregate wealth. Our specification performs well in explaining the cross-section of average returns.     

Earnings-Based Bonus Compensation

This article studies the cost of contingent earnings-based bonus compensation. We assume that the firm has normal and abnormal earnings. The normal earnings result from normal firm activities and are modeled as an arithmetic Brownian motion. The abnormal earnings result from surprising activities (e.g., introduction of an unexpected new product, an unexpected strike) and are modeled as a compound Poisson process where the earnings jump sizes have a normal distribution. We investigate, in a simple general equilibrium model, how normal and abnormal earnings affect the cost of contingent bonus compensation to the firm.     

Unobservable heterogeneity and rational learning: Pool-specific versus generic mortgage-backed security prices

Previous mortgage prepayment and valuation models assume that two mortgage pools with the same observable characteristics should behave indistinguishably. However, even pools with apparently identical characteristics often exhibit markedly different prepayment behavior. The sources of this heterogeneity may be unobservable, but we can infer information about a pool from its prepayment behavior over time. This article develops a methodology for using this information to calculate pool-specific mortgage-backed security prices. Knowledge of these prices is important both for portfolio valuation and for determining the cheapest pool to deliver when selling mortgagebacked securities. We find that unobservable heterogeneity between mortgage pools is statistically significant, and that pool-specific prices, calculated for a sample of outwardly identical mortgage pools between 1983 and 1989, may differ greatly from any single representative price.     

A positive interest rate model with sticky barrier

This paper proposes an efficient model for the term structure of interest rates when the interest rate takes very small values. We make the following choices: (i) we model the short-term interest rate, (ii) we assume that once the interest rate reaches zero, it stays there and we have to wait for a random time until the rate is reinitialized to a (possibly random) strictly positive value. This setting ensures that all term rates are strictly positive.

Our objective is to provide a simple method to price zero-coupon bonds. A basic statistical study of the data at hand indeed suggests a switch to a different mode of behaviour when we get to a low level of interest rates. We introduce a variable for the time already spent at 0 (during the last stay) and derive the pricing equation for the bond. We then solve this partial integro-differential equation (PIDE) on its entire domain using a finite difference method (Cranck–Nicholson scheme), a method of characteristics and a fixed point algorithm. Resulting yield curves can exhibit many different shapes, including the S shape observed on the recent Japanese market.     

Trends,random walks,and tests of the permanent income hypothesis

Recent studies find that consumption is excessively sensitive to income. These studies assume that income is stationary around a deterministic trend. The data, however, do not reject the hypothesis that disposable personal income is a random walk with drift. If income is indeed a random walk, then the standard testing procedure is greatly biased toward finding excess sensitivity. Moreover, if income follows either a more general non-stationary process or a borderline stationary process, this procedure is also seriously biased.     

How Does a Development Moratorium Affect Development Timing Choices and Land Values?

This paper investigates how a development moratorium affects choices of development timing and land values in a framework where both the value of developed property evolves stochastically and the development costs are fully irreversible. We assume that a regulator initially announces that land is not allowed to be developed during a finite period of time in the future. A developer, thus, must decide whether to develop land before the timing ordinance is imposed, or after it expires. The development moratorium reduces the developer’s option value from waiting and, thus, accelerates development. We also use simulation analysis to demonstrate how the other factors that relate to the demand and supply conditions of the real estate market affect this accelerating effect.     

Growth and Institutions: A Review of the Evidence

Africa's disappointing economic performance, the East Asianfinancial crisis, and the weak record of the former Soviet Unionhave focused attention on the role of institutions in determininga economic growth. This article critically reviews the literaturethat tries to link quantitative measures of institutions, suchas civil liberties and property rights, with growth of grossdomestic product across countries and over time. An importantdistinction is made between indicators that measure the performanceor quality of institutions and those that measure politicaland social characteristics and political instability. The evidencesuggests a link between the quality of institutions and investmentand growth, but the evidence is by no means robust.      

Modeling Mortality With Jumps: Applications to Mortality Securitization

In this article, we incorporate a jump process into the original Lee–Carter model, and use it to forecast mortality rates and analyze mortality securitization. We explore alternative models with transitory versus permanent jump effects and find that modeling mortality via transitory jump effects may be more appropriate in mortality securitization. We use the Swiss Re mortality bond in 2003 as an example to show how to apply our model together with the distortion measure approach to value mortality-linked securities. Pricing the Swiss Re mortality bond is challenging because the mortality index is correlated across countries and over time. Cox, Lin, and Wang (2006) employ the normalized multivariate exponential tilting to take into account correlations across countries, but the problem of correlation over time remains unsolved. We show in this article how to account for the correlations of the mortality index over time by simulating the mortality index and changing the measure on paths.     

Editorial: PMM,the impact of research on practice,and the emerging Research Excellence Framework

This article discusses the management of public values in local public-private networks established for highly innovative infrastructure projects. It compares six Dutch projects in terms of conflicting public values, trade-offs between public values and preferred modes of management. Some public values were initially more important, but trade-offs changed them over time. Effective management of public values requires a shared culture rather than contracts.     

Exploring household financial strain dynamics

Rising energy and food prices are causing living standards to fall across Europe and straining household budgets. The longer-term outlook for households is unclear as the dynamics of financial strain are not well understood. We address four important research questions on financial strain dynamics by applying a dynamic random coefficients probit model with duration and occurrence dependence to De Nederlandsche Bank (DNB) Household Survey panel data. We find no evidence that households become habituated or sensitised to financial strain over time unlike in studies of responses to stress. Entry into household financial strain is less likely when the household can cope by increasing earnings from work or by borrowing from family and friends but not by the economically inactive entering employment. Our third result is that the persistence of financial strain can be explained by a mutually-enforcing negative cycle through worse health but not through marital conflict or more short-sighted and risk averse decision-making. Finally, we find that neither income or wealth shocks affect financial strain in contrast to other studies. Further research into understanding the experience of financial hardship is warranted in the light of the economic challenges caused by the current cost of living crisis.     

50+ Years of Diversification Announcements

This paper studies announcement returns from 4,764 mergers over 57 years to shed light on several controversies concerning corporate diversification. One prominent view is that diversification destroys value because of agency problems or internal investment distortions, but we find that combined (acquirer plus target) announcement returns are significantly positive for diversifying mergers throughout the period, and no lower than the returns for related mergers. The returns from diversifying acquisitions fell after 1980, and investors rewarded mergers involving financially constrained firms before but not after 1980, consistent with the idea that the value of internal capital markets declined over time.     

Persistency of financial distress amongst Italian households: Evidence from dynamic models for binary panel data

This paper builds on existing studies on households’ financial distress and provides new evidence on the determinants of financial hardship in Italy and its persistence over time. It suggests a quantitative definition of financial distress based on the distribution of net wealth, and tests whether the probability of experiencing financial difficulty is persistent over time, using (random and fixed effects) dynamic models for binary panel data. The analysis exploits the longitudinal component of the Bank of Italy Survey on Household Income and Wealth for the period 1998–2006. Its results show that, after accounting for unobserved heterogeneity, past values of the outcome variable play a large part in explaining the probability of experiencing financial distress. In addition, the probability of financial vulnerability decreases with income and greater sophistication of the household portfolio and, at least in one of the model specifications, increases in areas with higher unemployment rates.     

Firms’ histories and their capital structures

This paper examines how cash flows, investment expenditures, and stock price histories affect debt ratios. Consistent with earlier work, we find that these variables have a substantial influence on changes in capital structure. Specifically, stock price changes and financial deficits (i.e., the amount of external capital raised) have strong influences on capital structure changes, but in contrast to previous conclusions, we find that over long horizons their effects are partially reversed. These results indicate that although firms’ histories strongly influence their capital structures, over time their capital structures tend to move towards target debt ratios that are consistent with the tradeoff theories of capital structure.     

PORTFOLIO FORMATION,MEASUREMENT ERRORS,AND BETA SHIFTS: A RANDOM SAMPLING APPROACH

This article demonstrates that the portfolio approach could suffer a serious problem when the sorting variables contain not only true values but also measurement errors. The grouped measurement errors will be embedded into the data used to test financial models and further bias the testing results. To correct for this measurement‐error problem, I develop a random sampling approach to form portfolios. Results from this new methodology are unbiased and robust. By applying this methodology to investigate beta shifts, I show that the previous results about beta shifts are driven by measurement errors. The actual beta shift pattern is more complicated than that predicted by previous studies. The risk shift hypothesis is unlikely to explain the mean‐reversion puzzle for stock returns. JEL classification: Gil, C43.     

The value of a neighborhood street with reference to the cul-de-sac

This article provides empirical evidence from Halifax, Nova Scotia, confirming the view that the type of neighborhood street can affect home values. The study identifies two categories of streets-the cul-de-sac and the grid-and measures their impacts on home value. The hypothesis that the cul-de-sac would attract premium values was supported by the study. In this study, the cul-de-sac generated a 29 percent price premium over the grid street pattern. The study concludes with a discussion of planning and development implications.