Knowledge that Transforms

Motivated by public policy debates about bank consolidation and conflicting theoretical predictions about the relationship between bank concentration, bank competition and banking system fragility, this paper studies the impact of national bank concentration, bank regulations, and national institutions on the likelihood of a country suffering a systemic banking crisis. Using data on 69 countries from 1980 to 1997, we find that crises are less likely in economies with more concentrated banking systems even after controlling for differences in commercial bank regulatory policies, national institutions affecting competition, macroeconomic conditions, and shocks to the economy. Furthermore, the data indicate that regulatory policies and institutions that thwart competition are associated with greater banking system fragility.

Stock index tracking requires to build a portfolio of stocks (a replica) whose behavior is as close as possible to that of a given stock index. Typically, much fewer stocks should appear in the replica than in the index, and there should be no low frequency or integrated (persistent) components in the tracking error. The latter property is not satisfied by many commonly used methods for index tracking. These are based on the in-sample minimization of a loss function, but do not take into account the dynamic properties of the index components. Moreover, most existing methods do not take into account the known structure of the index weight system. In this paper we represent the index components with a dynamic factor model. In this model the price of each stock in the index is driven by a set of common and idiosyncratic factors. Factors can be either integrated or stationary. We develop a procedure that, in a first step, builds a replica that is driven by the same persistent factors as the index. This procedure is grounded in recent results which suggest the application of principal component analysis for factor estimation even for integrated processes. In a second step, it is also possible to refine the replica so that it minimizes a specific loss function, as in the traditional approach. In both steps the replica weights depend on the existing information on the index weights system. An extended set of Monte Carlo simulations and an application to the most widely used index in the European stock market, the EuroStoxx50 index, provide substantial support for our approach.

This study examines two important issues underlying realized volatility and correlation estimators. First, an empirical inquiry is conducted to assess whether Bax and Eurodollar futures tick-by-tick data can be characterized as marked-point processes. Second, ARMA, neural network, GARCH-BEKK, and naive volatility and correlation forecasts are compared in an out-of-sample context when a trader prices an interest rate spread option based on those forecasts and simultaneously delta-hedges her position. Other loss functions are also considered. Competing volatility forecasts are also compared to implied volatilities.

Systemic crises can have grave consequences for investors in international equity markets, because they cause the risk-return trade-off to deteriorate severely for a longer period. We propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton [Merton, R.C., 1969. Lifetime portfolio selection under uncertainty: The continuous time case. Review of Economics and Statistics 51, 247–257]-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises greatly affects asset allocation decisions, while the costs of ignoring them is substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to the crisis prone emerging markets.

In this paper, we evaluate the relative immunization performance of the M-vector proposed by Nawalkha and Chambers (1997) [Nawalkha, S.K., Chambers, D.R., 1997. The M-vector model: derivation and testing of extensions to M-squared. The Journal of Portfolio Management 23, 92–98], using data for the Portuguese government debt market. Empirical results show that: (i) immunization models (single- and multi-factor) remove most of the interest rate risk underlying a more naïve maturity strategy; (ii) duration-matching portfolios constrained to include the maturity bond and formed using a single-factor model provide the best immunization performance overall, particularly in highly volatile term structure environments and shorter holding periods; (iii) varying the rebalancing frequency and the investment horizon shows that these results are less robust for Portugal than for other countries.

This paper focuses on the strategic role of corporate venture financing carried out by a corporation (a headquarter). When the headquarter finances a venture through its corporate venture-financing arm, it can increase the complementarity between products of the venture and the headquarter. The effect of having an increase in complementarity is a softening of ex post product market competition with rival products. Hence, in deciding whether to finance the venture, the headquarter faces a trade-off between, on the one hand, being more aggressive ex post in the product market, and, on the other hand, using venture financing to soften ex post competition with substitute products.

Forward rates of European currencies against the private and official ECU exhibit a bias similar to the one found in other data: the Cumby–Obstfeld–Fama (COF) regression coefficients are systematically below unity, and two thirds of them are negative. We use the discount of the private ECU relative to the official ECU as a measure of market scepticism or mistrust. In one view, this sentiment is based on peso risk: fears of realignments, and possibly also the risk of a meltdown of the private ECU relative to the official one. Alternatively, the discount just reflects fads and fashions. Dichotomizing the data on the basis of the size of the discount in the private ECU, we find that the COF beta strongly depends on the degree of mistrust and that the negative COF coefficients are generated by typically less than 20% of the data. But the pattern fits the fads and fashion view better than the peso theory. If the sentiment factor contains a conventional risk premium at all, then this risk premium is definitely not the one predicted by Bansal [Bansal, R., 1997. An exploration of the forward premium puzzle in currency markets. Review of Financial Studies 10, 369–403]. Nor is the sentiment factor proxying for Huisman et al.’s [Huisman, R., Koedijk, K., Kool, C., Nissen, F., 1998. Extreme support for uncovered interest parity. Journal of International Money and Finance 17, 211–228] transaction-cost effects.

It has been claimed that the ability of emerging markets to adopt optimal stabilization policies is hampered by a number of factors. Among them, it has been recently emphasized the role of financial instability, inefficiencies, and financial market imperfections. It is claimed here that the current financial regulatory paradigm, embodied in Basel II, may improve financial stability but reinforces cyclicality. Therefore, countries should emphasize financial efficiency since it would lead to enhanced financial stability, without increasing cyclicality.

This study compares the issuance costs of Eurobonds before and after the completion of the Economic and Monetary Union (EMU) in 2002. We find that the introduction of the Euro has significantly reduced the issue cost of Euro-denominated bonds compared to bonds denominated in the legacy currencies. The reduction in issue cost is not due to a decrease in underwriter compensation, but rather to the elimination of underpricing (the difference between the market price after trading commences and the offering price). Underwriter fee has declined substantially after the completion of the EMU, but this decline has been offset by an increase in underwriter spread (the difference between the offering price and the guaranteed price to the issuer), leaving total underwriter compensation unchanged. The EMU is also associated with significant reductions in bond maturity and syndicate size, consistent with its expected effects on liquidity and issue costs in the Eurobond market.

Utilizing a bank-lending channel framework, we investigate the effects of expansionary and contractionary policy separately on the loan behavior of low-capital and high-capital banks, and between pre-Basel/FDICIA and post-Basel/FDICIA periods. Our results show that low-capital banks are adversely affected by contractionary policy. Expansionary policy, however, is not effective in stimulating the loan growth of low-capital banks. These results are consistent with lending channel predictions, but only hold in the post-Basel/FDICIA period when the capital constraint is stringent relative to the pre-Basel/FDICIA period. These asymmetric policy results have implications for the interaction of monetary and capital regulatory policies.