Knowledge that Transforms

We explore the valuation and hedging of discretely observed volatility derivatives using three different models for the price of the underlying asset: Geometric Brownian motion with constant volatility, a local volatility surface, and jump-diffusion. We begin by comparing the effects on valuation of variations in contract design, such as the differences between specifying log returns or actual returns and incorporating caps on the level of realized volatility. We then focus on the difficulties associated with hedging these products. Delta hedging strategies are ineffective for hedging volatility derivatives since they require very frequent rebalancing. Moreover, they provide limited protection in the jump-diffusion context. We study the performance of a hedging strategy for volatility swaps that establishes small, fixed positions in vanilla options at each volatility observation.

We focus on the economies of the North Atlantic Core during the 19th and early 20th centuries and find that an impressive variety of local financial institutions emerged to supply the needs of SMEs wherever there was sufficient demand for their services. Although these intermediaries had significant weaknesses, they were able to tap into local information networks and so extend credit to firms that were too young or small to secure funds from large regional or national institutions. In addition, by raising the return to savings for local households, they helped to mobilize significant new resources for economic development.

We propose an empirical model for deviations from long-run purchasing power parity (PPP) that simultaneously accounts for three key features: (i) adjustment toward PPP may occur via nominal exchange rates and relative prices at different speeds; (ii) different exchange rate regimes may generate regime shifts in the structural dynamics of PPP deviations; (iii) nonlinear reversion toward PPP in response to shocks. This empirical framework encompasses and synthesizes much previous empirical research. Using over a century of data for the G5 countries, we provide evidence that long-run PPP holds, the relative importance of nominal exchange rates and prices in restoring PPP varies over time and across different exchange rate regimes, and reversion to PPP occurs nonlinearly, at a speed that is fairly consistent with the nominal rigidities suggested by conventional open economy models.

Several works in the shopping-time and in the human-capital literature, due to the non-concavity of the underlying Hamiltonian, use first-order conditions in dynamic optimization to characterize necessity, but not sufficiency, in intertemporal problems. This note selects some works in these two areas and shows that optimality can be characterized, and some results quantitatively improved, by means of an application of Arrow’s [Arrow, K. J., 1968. Applications of control theory to economic growth. In: Dantzig, G.B., Veinott Jr., A.F. (Eds.), Mathematics of the Decisions Sciences. American Mathematical Society, Providence, RI] sufficiency theorem.

This paper investigates the effect of changes in health status on household financial wealth and financial portfolio choice. It is shown that the impact of health events on household financial and non-financial wealth is asymmetric. A diagnosis of a new disease leads to a larger decrease in financial wealth than in non-financial wealth. Moreover, we find that the puzzle pertaining to the relationship between health status and portfolio choice discussed in the extant literature generally disappears after controlling for differences in the amount of financial assets held by healthy and sick people. The results suggest that the effect of changes in health status on household financial portfolios is indirect. A health shock significantly reduces household total financial wealth, in turn leading households to restructure the composition of their financial assets.

This paper uses international panel data to examine the interrelationships among some commonly used measures of financial constraint. The analysis reveals the following insights: (1) firms with stronger financial positions are more investment-cash flow sensitive than firms with weaker financial positions even after controlling for size and dividend payout and (2) higher payout firms are more investment-cash flow sensitive than lower payout firms even after controlling for size and financial strength. Evidence regarding the impact of firm size that is documented originally becomes much weaker once financial health and dividend payout behavior are controlled for. Finally, additional analysis reveals that many of these results may be driven by the fact that firms possessing high cash flow volatility display lower investment-cash flow sensitivities.

Fiscal rules, such as the excessive deficit procedure and the stability and growth pact (SGP), aim at constraining government behavior. [Milesi-Ferretti, G., 2003. Good, bad or ugly? On the effects of fiscal rules with creative accounting, Journal of Public Economics, 88, 377–394] develops a model in which governments circumvent such rules by reverting to creative accounting. The amount of this depends on the reputation cost for the government and the economic cost of sticking to the rule. We provide empirical evidence of creative accounting in the European Union. We find that the SGP rules have induced governments to use stock-flow adjustments, a form of creative accounting, to hide deficits. The tendency to substitute stock-flow adjustments for budget deficits is especially strong for the cyclical component of the deficit, as in times of recession the cost of reducing the deficit is particularly large.

This paper presents recent research on access to finance by small and medium-size enterprises (SMEs). SMEs form a large part of private sector in many developed and developing countries. While cross-country research sheds doubt on a causal link between SMEs and economic development, there is substantial evidence that small firms face larger growth constraints and have less access to formal sources of external finance, potentially explaining the lack of SMEs’ contribution to growth. Financial and institutional development helps alleviate SMEs’ growth constraints and increase their access to external finance and thus levels the playing field between firms of different sizes. Specific financing tools such as leasing and factoring can be useful in facilitating greater access to finance even in the absence of well-developed institutions, as can systems of credit information sharing and a more competitive banking structure.

In this paper we develop a multi-period and multi-state portfolio credit risk model which is applicable to large dimensional portfolios like for example retail and mortgage portfolios. The model includes a methodology for estimation and simulation of systematic transition risk through a model for stochastic migration, a methodology for the modelling of recoveries in the case of stochastic collaterals as well as an approach to dimension reduction of the portfolio. One important application of our model is economic capital (EC) and a concept of EC based on the analogy with classical risk theory is introduced and the questions of allocation as well as risk-adjusted pricing based on the allocation of EC are structured and described. The model is illustrated by an extensive numerical example giving a concretization of the model as well as of several of the concepts introduced.

This paper examines the contribution of market makers to the liquidity and the efficiency of the options market in a unique setup of an order-driven computerized trading system, in which market makers and other participants operate under equitable conditions. The main findings are: (1) liquidity increased – a 60% increase in trading volume and a 35% decrease of bid–ask spreads; (2) the efficiency of shekel–euro options trading improved – deviations from put–call parity decreased significantly by 12%, and skewness decreased by about 30%. We also find that the net cost to the exchange is out weighted by the benefit to the trading public and that the presence of market makers encouraged trading between other participants far beyond their own trading.