Modeling the evolution of implied CDO correlations

CDO tranche spreads (and prices of related portfolio-credit derivatives) depend on the market’s perception of the future loss distribution of the underlying credit portfolio. Applying Sklar’s seminal decomposition to the distribution of the vector of default times, the portfolio-loss distribution derived thereof is specified through individual default probabilities and the dependence among obligors’ default times. Moreover, the loss severity, specified via obligors’ recovery rates, is an additional determinant. Several (specifically univariate) credit derivatives are primarily driven by individual default probabilities, allowing investments in (or hedging against) default risk. However, there is no derivative that allows separately trading (or hedging) default correlations; all products exposed to correlation risk are contemporaneously also exposed to default risk. Moreover, the abstract notion of dependence among the names in a credit portfolio is not directly observable from traded assets. Inverting the classical Vasicek/Gauss copula model for the correlation parameter allows constructing time series of implied (compound and base) correlations. Based on such time series, it is possible to identify observable variables that describe implied correlations in terms of a regression model. This provides an economic model of the time evolution of the market’s view of the dependence structure. Different regression models are developed and investigated for the European CDO market. Applications and extensions to other markets are discussed.     

Competition versus efficiency: What drives franchise values in European banking?

This paper investigates how stock market investors perceive the impact of market structure and efficiency on the long-run performance potential of European banks. To that end, a modified Tobin’s Q ratio is introduced as a measure of bank franchise value. This measure is applied to discriminate between the market structure and efficient-structure hypotheses in a coherent forward-looking framework, in which differences in banks’ horizontal and vertical differentiation strategies are controlled for. The results show that banks with better management or production technologies possess a long-run competitive advantage. In addition, bank market concentration does not affect all banks equally. Only the banks with a large market share in a concentrated market are able to generate non-competitive rents. The paper further documents that the forward-looking, long-run perspective and the noise-adjustment of the performance measure overcome most of the drawbacks associated with testing these hypotheses in a multi-country set-up. Finally, notwithstanding the international expansion of bank activities, the harmonization of regulation and the macroeconomic convergence in the European Union (EU15), we still find that country-specific macroeconomic variables have a significant impact on bank performance. The findings indicate that there is a trade-off between competition and stability that should be taken into account when assessing mergers or acquisitions.     

Pricing distressed CDOs with stochastic recovery

In this article, a framework for the joint modelling of default and recovery risk in a portfolio of credit risky assets is presented. The model especially accounts for the correlation of defaults on the one hand and correlation of default rates and recovery rates on the other hand. Nested Archimedean copulas are used to model different dependence structures. For the recovery rates a very flexible continuous distribution with bounded support is applied, which allows for an efficient sampling of the loss process. Due to the relaxation of the constant 40% recovery assumption and the negative correlation of default rates and recovery rates, the model is especially suited for distressed market situations and the pricing of super senior tranches. A calibration to CDO tranche spreads of the European iTraxx portfolio is performed to demonstrate the fitting capability of the model. Applications to delta hedging as well as base correlations are presented.     

Heterogeneous Popularity and Exporting Uncertainty

Empirical work shows that a considerable fraction of firms quit the export market soon after entrance. A natural interpretation to this quick exit from the export market is that firms did not predict the profitability of their variety correctly before entry. In this paper a firm heterogeneity model is put forward to account for this type of exporting uncertainty due to lack of information. Firms are heterogeneous with respect to the popularity of their good, technically the CES weight, and the popularity of a good varies across markets. Therefore, firms are uncertain about the profitability of their good in the export market. Upon payment of sunk export costs the popularity of the good is revealed and some firms stay in the export market while others leave. Comparative statics show that lower sunk export costs lead to higher probability that firms start to export, but to lower probability of export success. Lower fixed export costs instead lead to both a higher probability to start exporting and to be successful in exporting.     

Public Professionals and Policy implementation

Abstract

Nowadays, public policies often focus on economic values, such as efficiency and financial transparency. Public professionals often resist implementing such policies. We analyse this using the concept of ‘role conflicts’. We use a novel approach by conceptualizing and measuring role conflicts on the policy level, thereby linking policy implementation and social psychology research. We construct and test scales for policy-client, policy-professional and organizational-professional role conflicts. Using survey data, we show that policy-professional and policy-client role conflicts negatively influence the willingness of public professionals to implement policies. In concluding, we conceptualized and measured three role conflicts that can occur during policy implementation.     

Import prices,income, and inequality

We compare three theoretical explanations for the positive empirical relationship between importer income per capita and traded goods prices. A first explanation is that consumers with higher incomes demand higher quality goods with higher prices. A second explanation is that wealthier people exhibit an increased willingness to pay for necessary goods as more goods enter the consumption set in a hierarchic demand system, and can thus be charged higher markups. A third explanation is that consumers with higher incomes are more finicky regarding their preferred variety in an ideal variety framework and can thus be charged higher markups. We discriminate between these three theories by focusing on the effect of income inequality on trade prices. Based on a large dataset with bilateral HS6 level data on 1260 final goods categories from more than 100 countries between 2000 and 2004, we find a highly significant negative effect of income inequality on unit values. This contradicts both the demand for quality and finickyness theories, while providing support for the increased willingness to pay theory linked to hierarchic demand. These findings on income inequality do not falsify the quality expansion model and the ideal variety model per se. However, the results do argue for place of importance of hierarchic demand.     

Sector and importer determinants of prices for traded intermediates

While the literature on traded goods prices emphasizes final goods prices and related consumer theory to explain variation in goods prices with importer characteristics, trade in intermediates actually constitutes about two thirds of total trade. We propose a mechanism for explaining variations in the prices of intermediates as a function of importer characteristics, wherein production is vulnerable to failure and the probability of failure declines in the quality of intermediates. Higher wages mean a greater opportunity cost of failure, leading to a stronger demand for high-quality intermediates where firms face higher wages. We find empirical support for this mechanism in the case of intermediate goods using IV regressions. In addition, our findings indicate that while the cost of labour explains about one fifth of variation in imported intermediate prices, it is a non-significant determinant of imported final goods prices.