The anatomy of financial crises: Evidence from the emerging ADR market

We study the anatomy of recent financial crises in Mexico, East Asia, Russia, Brazil, Turkey, and Argentina by investigating the efficiency and pricing of the emerging American depositary receipt (ADR) market. We use a non-parametric technique to test for persistent regime shifts in two basic structural relationships for ADR returns in 20 emerging countries — identified via arbitrage and capital mobility considerations — that should always hold in efficient and integrated capital markets. We find that those “normal” market conditions were instead often violated in proximity of financial crises: The law of one price often weakened (by 54% on average) and domestic sources of risk became more important (often by more than 100%) for many emerging ADRs. We also find the likelihood of these regime shifts to be related to proxies for uncertainty among investors, exchange rate volatility, trade linkages, and liquidity (but not stock market trends, currency devaluations, capital flight, or capital controls).     

The Illusion of Merit and the Demons of Economic Meritocracy: Which are the Legitimate Expectations of the Market?

Journal of Business Ethics - Meritocracy is gaining momentum in public discourse, being close to the determinants of people’s demand of social justice (equality of opportunity, social...     

Monetary policy and financial stability: What role for the futures market?

This paper examines interactions between monetary policy and financial stability. There is a general view that central banks smooth interest rate changes to enhance the stability of financial markets. But might this induce a moral hazard problem, and induce financial institutions to maintain riskier portfolios, the presence of which would further inhibit active monetary policy? Hedging activities of financial institutions, such as the use of interest rate futures and swap markets to reduce risk, should further protect markets against consequences of unforeseen interest rate changes. Thus, smoothing may be both unnecessary and undesirable. The paper shows by a theoretical argument that smoothing interest rates may lead to indeterminacy of the economy's rational expectations equilibrium. Nevertheless, our empirical analysis supports the view that the Federal Reserve smoothes interest rates and reacts to interest rate futures. We add new evidence on the importance for policy of alternative indicators of financial markets stress.     

To Invest or not to Invest: A real options approach to FDIs and tax competition

Foreign investment decisions of firms are often characterized by investment irreversibility, uncertainty, and the ability to choose the optimal timing of foreign investments. We embed these characteristics into a real option theory framework to analyze international competition among countries to attract mobile investments when firms, after the investment is sunk, can shift profit to low tax countries by transfer pricing. We find that an increase in the uncertainty of profit income reduces the equilibrium tax rates, whilst lower investment costs or larger profits, counteracts the negative fiscal externality of tax competition leading to higher equilibrium tax rates. JEL Code H25     

Does bank capital affect lending behavior?

This paper investigates the existence of cross-sectional differences in the response of lending to monetary policy and GDP shocks owing to differences in bank capitalization. It adds to the literature by using the excess capital-to-asset ratio, which can better control the riskiness of banks' portfolios, and by disentangling the effects of the “bank lending channel” from those of the “bank capital channel.” The results, based on a sample of Italian banks, indicate that bank capital matters in the propagation of different types of shocks to lending, owing to the existence of regulatory capital constraints and imperfections in the market for bank fund-raising.     

The new Capital Accord and banks’ lending decisions

Capital requirements (‘pillar one’ of the new Capital Accord) rising with the increase in borrowers’ PDs were thought as being likely: (i) to have a serious impact on the financing of small and medium-sized enterprises (usually riskier than large corporates) and (ii) to increase the procyclicality of the supply of credit.

The aim of this paper is to provide an empirical evaluation of the possible impact of the new Accord proposals on the lending policies of Italian banks. We compare the interest rate charged to a large set of Italian firms with the cost brought about by the change in the calculation of capital requirements. Since the two variables move together in response to an increase in borrowers’ PDs, we conclude that the new regulatory approach to measuring capital adequacy appears consistent with banks’ own risk evaluations. This result is supported by a ‘stress testing’ exercise: the relationship also holds in a distressed economic scenario, which replicates the financial conditions of the Italian corporate sector in the 1993–1994 recession.     

Central bank intervention and the intraday process of price formation in the currency markets

We propose a novel theory of the impact of sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which i) a rational Central Bank faces a trade-off between policy motives and wealth maximization; ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position; and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by assumption. In this setting, and consistent with available empirical evidence, we find that i) the mere likelihood of a future intervention—even if expected, non-secret, and uninformative—is sufficient to generate endogenous effects on exchange rate levels, to increase exchange rate volatility, and to impact bid-ask spreads; and ii) these effects are exacerbated by the intensity of dealership competition, the extent of the Central Bank's policy trade-off, and the credibility of its threat of future actions.     

Preferences,entry, and market structure

We provide a unified approach to imperfect (monopolistic, Bertrand, and Cournot) competition when preferences are symmetric over a finite but endogenous number of goods. Markups depend on the Morishima elasticity of substitution and on the number of varieties. The comparative statics of free‐entry equilibria is examined, establishing the conditions for markup neutrality with respect to income, market size, and productivity. We compare endogenous and optimal market structures for several non‐CES examples. With a generalized linear direct utility, the markup can be constant and optimal under monopolistic competition, and nonmonotonic in the number of firms under Bertrand or Cournot competition.     

LONG HORIZONS,HIGH RISK AVERSION,AND ENDOGENOUS SPREADS

For an investor with constant absolute risk aversion and a long horizon, who trades in a market with constant investment opportunities and small proportional transaction costs, we obtain explicitly the optimal investment policy, its implied welfare, liquidity premium, and trading volume. We identify these quantities as the limits of their isoelastic counterparts for high levels of risk aversion. The results are robust with respect to finite horizons, and extend to multiple uncorrelated risky assets. In this setting, we study a Stackelberg equilibrium, led by a risk‐neutral, monopolistic market maker who sets the spread as to maximize profits. The resulting endogenous spread depends on investment opportunities only, and is of the order of a few percentage points for realistic parameter values.     

Local volatility under rough volatility

Several asymptotic results for the implied volatility generated by a rough volatility model have been obtained in recent years (notably in the small-maturity regime), providing a better understanding of the shapes of the volatility surface induced by rough volatility models, supporting their calibration power to SP500 option data. Rough volatility models also generate a local volatility surface, via the so-called Markovian projection of the stochastic volatility. We complement the existing results on implied volatility by studying the asymptotic behavior of the local volatility surface generated by a class of rough stochastic volatility models, encompassing the rough Bergomi model. Notably, we observe that the celebrated “1/2 skew rule” linking the short-term at-the-money skew of the implied volatility to the short-term at-the-money skew of the local volatility, a consequence of the celebrated “harmonic mean formula” of [Berestycki et al. (2002). Quantitative Finance, 2, 61–69], is replaced by a new rule: the ratio of the at-the-money implied and local volatility skews tends to the constant $1/(H+3/2)$ (as opposed to the constant 1/2), where H is the regularity index of the underlying instantaneous volatility process.