ECONOMIC EFFICIENCY AND "PRUDENCE" ANALYSIS OF POWER PLANT INVESTMENT

The various deregulation proposals for the electric utility sector rely on market forces to provide incentives. Even within the traditional regulatory framework, using market behavior instead of regulators' views as a criterion for regulatory decisions is part of the spectrum of deregulation proposals. This paper proposes such an implicit deregulation of rate base decisions. It presents an efficiency standard with which public utility commissions (PUCs) should conduct their "prudence" analyses of power plant construction costs. Prudence reviews, as typically conducted by PUCs, are likely to change the risk structure in regulated sectors so as to make both ratepayers and shareholders worse off. Moreover, the correct perspective for such analyses is ex ante rather than ex post. This means that the expected costs and benefits of alternative actions are the correct parameters for evaluating prudence, and that the interests of ratepayers are consistent only with this economic efficiency approach to prudence analysis. Average industry behavior is the correct standard for implementing the efficient prudence criterion. This paper describes an alternative procedure that PUCs can use to conduct prudence reviews correctly.     

Shadow Banks and Macroeconomic Instability

We develop a macroeconomic model in which commercial banks can offload risky loans to a “shadow” banking sector, and financial intermediaries trade in securitized assets. The model can account both for the business cycle comovement between output, traditional bank, and shadow bank credit, and for the behavior of macroeconomic variables in a liquidity crisis centered on shadow banks. We find that following a liquidity shock, stabilization policy aimed solely at the market in securitized assets is relatively ineffective.     

How Integrated are Credit and Equity Markets? Evidence from Index Options

We study the extent to which credit index (CDX) options are priced consistent with S&P 500 (SPX) equity index options. We derive analytical expressions for CDX and SPX options within a structural credit-risk model with stochastic volatility and jumps using new results for pricing compound options via multivariate affine transform analysis. The model captures many aspects of the joint dynamics of CDX and SPX options. However, it cannot reconcile the relative levels of option prices, suggesting that credit and equity markets are not fully integrated. A strategy of selling CDX volatility yields significantly higher excess returns than selling SPX volatility.     

Who Owns What? A Factor Model for Direct Stockholding

We build a cross-sectional factor model for investors' direct stockholdings and estimate it using data from almost 10 million retail accounts in the Indian stock market. Our model identifies strong investor clienteles for stock characteristics, most notably firm age and share price, and for particular clusters of stock characteristics. These clienteles are intuitively associated with investor attributes such as account age, size, and diversification. Coheld stocks tend to have higher return covariance, inconsistent with simple models of diversification but suggestive that clientele demands influence stock returns.