Knowledge that Transforms

There is considerable heterogeneity in the development of derivatives markets in different countries. The question is: why? This paper addresses this question in the context of major derivatives markets in Latin America. The largest derivatives exchanges in Latin America are located in Argentina, Brazil, and Mexico. In addition, over-the-counter (OTC) markets exist in Chile and Peru. Excluding Peru, Chile's derivatives market is to date the least developed. We show that this is due to regulatory constrains and illiquidity. Domestic transactions are OTC, and consist mostly of exchange rate forwards. Recent changes in the Central Bank of Chile's exchange rate policy have not had a considerable impact on the aggregate trading volume of forwards. However, amendments made to the Law of Capital Markets in 2001 bring the possibility of having a more developed derivatives market in the future.

Using a unique set of banking data containing both originally-reported and subsequently-revised financial variables, we study accounting restatements. Our results indicate the worse a bank's financial condition, the more likely it is for originally-reported data to understate financial losses. Also, we find supervisory exams have an important role in uncovering financial problems and prompting accounting restatements to correct loss underreporting. While revisions are directly related to financial difficulties, exam-based restatements are evident at even the earliest stages of deterioration, indicating substantial accounting misstatements—at both banks and other types of companies—can occur well outside severe business circumstances.

The traditional approach to the central bank's lender of last resort function emphasizes the trade-off between being too ‘tough’, and thus increasing the likelihood that the failure of a single bank hampers the confidence in the whole banking system, and being too ‘soft’, thereby creating incentives for banks to take on excessive risk. In contrast with this view, we show that a central bank, by announcing and committing ex-ante to bail out insolvent institutions in times of adverse macroeconomic conditions, can create a risk-reducing ‘value effect’ that outweighs the moral hazard component of the policy, and thus lowers bank risk.

What are the causes and consequences of commonality in liquidity? We examine this issue using a model of liquidity trading in which liquidity shocks are decomposed into common (systematic) and idiosyncratic components. We show that common liquidity shocks do not give rise to commonality in trading volume. Indeed, trading volume is independent of systematic liquidity risk, and this risk is always priced irrespective of market liquidity. In contrast, idiosyncratic liquidity shocks create liquidity demand and volume, and investors can diversify their risk by trading. Hence, pricing of the risk of idiosyncratic liquidity shocks depends on market liquidity, with idiosyncratic liquidity risk being fully priced only in perfectly illiquid markets. While trading volume increases with the variance of idiosyncratic liquidity shocks, price volatility increases with the variance of both idiosyncratic and systematic liquidity shocks. Surprisingly, our results are largely independent of the number of different securities traded in the market. When asset returns are uncorrelated, there is no transmission of liquidity across assets even when investors experience common liquidity shocks, suggesting that such liquidity shocks may not be the source of commonality in liquidity across assets detected in the literature. However, under limited conditions, more liquid securities can act as substitutes for less liquid securities. Overall, our findings suggest that common factors in liquidity may be the outcome of covariation in investor heterogeneity (e.g., as measured by co-movements in the volatility of idiosyncratic liquidity shocks) rather than of common liquidity shocks. Moreover, we find that different liquidity proxies measure different things, which has implications for future empirical analysis.

When potential bidders for a target firm are heterogeneous, standard auction methods for selling the firm are not optimal, as they treat the bidders symmetrically. In a two-bidder contest, one way to discriminate against the stronger bidder is to impose an order of moves. A simple “matching auction” can achieve this objective, in which the “strong” bidder is asked to make a first and final offer, and the other bidder is asked to match this bid. We consider two sources of bidder heterogeneity in a common-value setting: differences in initial toeholds, and asymmetric effects of the bidders' private signals on value. The matching auction results in a higher expected selling price than the standard auctions when the asymmetry is sufficiently large. Other properties of the matching auction are discussed.