Knowledge that Transforms

Abstract We propose a simple model that is suitable for evaluating alternative bank capital regulatory proposals for market risk. Our model formalizes the conflict between bank objectives and regulatory goals. Banks' decisions represent a tension between their desire to exploit the deposit-insurance put option and their desire to preserve franchise value. Regulators seek to balance the social value of deposits in mediating transactions against the deadweight costs of failure resolution. Our social welfare criterion is standard: a weighted average agents' utilities. We demonstrate that banks do not incrementally alter their portfolio risk as the economic environment changes. Rather, banks either choose the minimal feasible risk or the maximal feasible risk. This pattern, in turn, drives regulatory decisions: The first goal of the regulator is to induce banks to choose the minimal risk level. For all nontrivial cases, unregulated banks fail to choose the first-best allocations. Traditional ex-ante capital requirements can induce banks to choose the socially-optimal level of portfolio risk, but the required capital is often inefficiently high. In contrast, variants of the Federal Reserve Board's precommitment proposal imply far smaller efficiency losses, and achieve allocations at or nearthe first-best for most reasonable model specifications. The ex-post penalties required for the optimal implementation of precommitment are not excessively large. The welfare gains from precommitment are even higher when the precommitment penalty function is precluded from sending banks into default. We conclude that state-contingent regulatory mechanisms, of which the precommitment approach is an example, offer the possibility of substantial gains in regulatory efficiency, relative to traditional state non-contingent regulation.

Brian Huge, David Lando; Swap Pricing with Two-Sided Default Risk in a Rating-Based Model *, European Finance Review, Volume 3, Issue 3, 1 January 1999, Pa

Abstract With constrained portfolios contingent claims do not generally have a unique price that rules out arbitrage opportunities. Earlier studies have demonstrated that when there are constraints onthe hedge portfolio, a no-arbitrage price interval for any contingent claim exists. I consider the more realistic case where the constraints are imposed on the total portfolio of each investor and define reservation buying and selling prices for contingent claims. I derive properties of these prices, show how they can be computed numerically, and study two simple examples in which the reservation prices and the corresponding hedging strategies are compared to the Black–Scholes setting. JEL classification C63, D52, G11, G13.

Abstract Under what conditions will a multinational corporation alter its operations to manage its risk exposure? We show that multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Operational hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. When the fixed costs of establishing a plant are low or the variability of the exchange rate is high, a firm may benefit from establishing plants in both the domestic and foreign location. Capacity allocated to the foreign location relative to the domestic location will increase when the variability of foreign demand increases relative to the variability of domestic demand or when the expected profit margin is larger. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate and consequently the optimal financial hedging policy cannot be implemented with forward contracts alone. We show that the optimal financial hedging policy can be implemented using foreign currency call and put options and forward contracts.

Pierre Mella-Barral; Comment on ‘Bank Capital Standards for Market Risk: A Welfare Analysis’, Review of Finance, Volume 2, Issue 2, 1 January 1999, Pages 159–16

Abstract This paper discusses the pitfalls in the pricing of barrier options using approximations of the underlying continuous processes via discrete lattice models. To prevent from numerical deficiencies, the space axis is discretized first, and not the time axis. In a Black–Scholes setup, models with improved convergence properties are constructed: a trinomial model and a randomized trinomial model where price changes occur at the jump times of a Poisson process. These lattice models are sufficiently general to handle options with multiple barriers: the numerical difficulties are resolved and extrapolation yields even more accurate results. In a last step, we extend the Black–Scholes setup and incorporate unpredictable discontinuous price movements. The randomized trinomial model can easily be extended to this case, inheriting its superior convergence properties. JEL classification: C63, G12, G13.