Knowledge that Transforms

We examine a set of equity index-linked bonds that provide the same payoff as an investment in an equity index, but are relatively illiquid. We demonstrate that these securities sell at a discount relative to their underlying value and hence have higher expected returns. We show that this apparent mispricing can be attributed to the illiquidity of the bonds. Trading costs for equity-linked bonds, as measured by bid-ask spreads, are free of any asymmetric information or inventory holding cost component; hence the only illiquidity component left is clearing costs. This study shows that, even in the absence of asymmetric information and inventory holding costs, illiquidity depresses asset prices and therefore increases expected security returns. Using an ex ante measure of the expected return premium due to illiquidity, we link the time-series variation in the illiquidity premium to security-specific attributes related to their marketability. We show that liquidity risk has a systematic component, and relate this market-wide factor to a number of macroeconomic variables that have previously been shown to be related to illiquidity.

We study opening prices set simultaneously for German and French stocks in Frankfurt and Paris. In our model investors and traders based in the same country as the firm have better information on its value than foreign traders. Our theory implies that prices set on the domestic market differ from (and are more informationally efficient than) prices set on the foreign market. Empirically, we find significant price discrepancies between home and foreign prices, consistent with lack of integration of international financial markets. For German stocks, home prices are found to be informationally more efficient than foreign prices. The informational efficiency of French stock prices is comparable in the two markets when Frankfurt traders can observe Paris preopening prices before the opening.

We analyze the empirical predictions of ambiguity aversion in intertemporal heterogenous agents economies. We examine equilibria for two tract able wealth–homothetic settings of ambiguity aversion in continuous time. Each setting is motivated by a different robust control optimization problem. We show that ambiguity aversion affects optimal portfolios in a way that is similar to an increase in risk aversion. A distinct property of our second setting of ambiguity aversion is that this increase is state dependent, highly pronounced at moderate portfolio exposures and reduces equity-market participation. In general equilibrium, ambiguity aversion raises the equity premium and lowers interest rates. A distinct feature of our second setting of ambiguity aversion is that the equity premium part due to ambiguity aversion dominates when volatility is low.

Empirical evidence shows that the implied volatility smiles for index options are significantly steeper than those for individual options. We propose a model setup where we start from the joint dynamics of the stocks and where the index value is a weighted sum of individual stock prices. Then the differences between the index smile and the smiles for individual stocks are entirely determined by the dependence structure among the stocks. We illustrate our idea in a jump-diffusion framework where both the diffusion and the jumps are decomposed into common and idiosyncratic components. Empirical data for options on the German stock index DAX and on Deutsche Bank are used to show that the model can explain the stylized facts on implied volatility smiles.

This paper focuses on the joint dynamics of yield spreads derived from government bonds issued by member states of the European Monetary Union (EMU). A descriptive analysis shows that there are substantial and volatile spreads between zero coupon yields of EMU member countries and German Bund yields. These yield spreads form an important source of additional risk that has to be taken into account by any pricing or risk management model dealing with EMU government bonds. We extract risk factors driving observed yield spreads by employing a multi-issuer version of the model originally proposed by Duffie and Singleton (1999). We adopt a state-space approach to implement the model whereby we can extract factor series and model parameters simultaneously. Our findings indicate that a parsimonious two-factor version of the multi-issuer model sufficiently captures the main features of the data. In this model the first factor turns out to be related to long term yield spreads across different issuers, whereas the second factor is related to short term yield spreads. Our evidence suggests that EMU government bond spreads are related to corporate bond spreads and swap spreads whereas we do not find evidence for a significant impact of macroeconomic or liquidity related variables.

We provide a general framework for analyzing the effects of insider trading on real investment and welfare as well as the consequences of different regulatory policies in a model where all traders are rational expected-utility maximizers and aware of their position in the market. We find that: with costly information acquisition, an “abstain-or-disclose” rule tends to be optimal; with free information acquisition, laissez-faire is better. This suggests enforcing an abstain-or-disclose rule with a high standard of proof for inside information. Our approach also uncovers the pitfalls of welfare analysis in the noise-trader model.

This study analyzes the risk-taking behavior of mutual funds in response to their relative performance over the 1992 to 1999 period. Our results show that managers of funds whose performance is closer to that of the top performing funds have greater incentives to increase their portfolios' risk than managers at the top who exhibit a tendency to lock in their positions. The evidence suggests that termination risk imposes a constraint on the risk taking behavior of underperforming fund managers and the winner takes all phenomenon generates a strong incentive for the fund managers to be the top manager. We also analyze the difference in the risk taking behavior of funds managed by multiple managers and single managers.

This paper explains the rationale behind deposit collateral that has not been discussed in the literature on financial contracting. In our model extending Hart and Moore (1998) to account for liquidity shocks, deposit collateral has potentially two important effects: the enhancement of pledgeability and the provision of liquidity. We show that only if liquidity shocks are stochastic, both effects are significant and overall efficiency is improved. This improvement is the raison d'être of deposit collateral. The result also establishes a unique role for banks, since deposit collateral can only be taken by these financial institutions. Furthermore, it is shown that the collateral can be implemented in the form of compensating balance requirements with or without commitment loans and is attached with less restrictive efficiency conditions than alternative lending arrangements.

Robert Z. Aliber, Bhagwan Chowdhry, Shu Yan; Some Evidence that a Tobin Tax on Foreign Exchange Transactions May Increase Volatility *, European Finance Re