Knowledge that Transforms

This short paper resolves an apparent contradiction between Feldman's (1989) and Riedel's (2000) equilibrium models of the term structure of interest rates under incomplete information. Feldman (1989) showed that in an incomplete information version of Cox, Ingersoll, and Ross (1985), where the stochastic productivity factors are unobservable, equilibrium term structures are ‘interior’ and bounded. Interestingly, Riedel (2000) showed that an incomplete information version of Lucas (1978), with an unobservable constant growth rate, induces a ‘corner’ unbounded equilibrium term structure: it decreases to negative infinity. This paper defines constant and stochastic asymptotic moments, clarifies the apparent conflict between Feldman's and Riedel's equilibria, and discusses implications. Because productivity and growth rates are not directly observable in the real world, the question we answer is of particular relevance.

Using data from the Frankfurt Stock Exchange we analyze price formation and liquidity in a non-anonymous environment with similarities to the floor of the NYSE. Our main hypothesis is that the non-anonymity allows the specialist to assess the probability that a trader trades on the basis of private information. He uses this knowledge to price discriminate. This can be achieved by quoting a large spread and granting price improvement to traders deemed uninformed. Consistent with our hypothesis we find that price improvement reflects lower adverse selection costs but does not lead to a reduction in the specialist's profit. Further, the quote adjustment following transactions at the quoted bid or ask price is more pronounced than the quote adjustment after transactions at prices inside the spread. Our results indicate that anonymity comes at the cost of higher adverse selection risk.

Numerous psychological studies show that weather conditions affect people's mood and that mood states are correlated with people's subjective evaluation of future probabilities. In this paper, a new approach is developed and asset market data are employed to test the mood-subjective probability relation. Cloud cover and precipitation volume serve as two mood proxies. Our statistical analysis suggests that bad mood states are characterized by investors placing higher probabilities on adverse events.

We consider the design and estimation of quadratic term structure models. We start with a list of stylized facts on interest rates and interest rate derivatives, classified into three layers: (1) general statistical properties, (2) forecasting relations, and (3) conditional dynamics. We then investigate the implications of each layer of property on model design and strive to establish a mapping between evidence and model structures. We calibrate a two-factor model that approximates these three layers of properties well, and show that a flexible specification for the market price of risk is important in capturing the stylized evidence in forecasting relations while factor interactions are indispensable in generating the hump-shaped dynamics of bond yields.

Multiple delivery specifications exist on nearly all commodity futures contracts. Sellers are typically allowed to choose among several grades of the underlying commodity. On the delivery day, the futures price converges to the spot price of the cheapest-to-deliver grade rather than to that of the par-delivery grade of the commodity, thereby imposing an additional delivery risk on hedgers. This paper derives the optimal production and futures hedging strategy for a risk-averse competitive firm facing delivery risk. We show that the option value of the multiple delivery specification induces the firm to produce more with than without the delivery risk if the firm gauges this value higher than the market. We further show that if the delivery risk is additively related to the commodity price risk, the firm optimally under-hedges its risk exposure. On the other hand, if the delivery risk is multiplicatively related to the commodity price risk, the firm may optimally choose an under- or over-hedge which we illustrate using a numerical example.

This paper proposes a self-financing trading strategy that minimizes the expected shortfall locally when hedging a European contingent claim. A positive shortfall occurs if the hedger is not willing to follow a perfect hedging or a superhedging strategy. In contrast to the classical variance criterion, the expected shortfall criterion depends only on undesirable outcomes where the terminal value of the written option exceeds the terminal value of the hedge portfolio. Searching a strategy which minimizes the expected shortfall is equivalent to the iterative solution of linear programs whose number increases exponentially with respect to the number oftrading dates. Therefore, we partition this complex overall problem into several one-period problems and minimize the expected shortfall only locally, i.e., only over the next trading period. This approximation is quite accurate and the number of linear programs to be solved increases only linearly with respect to the number of trading dates.

In this paper we set up a model of start-up finance under double moral hazard. Entrepreneurs lack own resources and business experience to develop their ideas. Venture capitalists can provide start-up finance and commercial support. The effort put forth by either agent contributes to the firm's success, but is not verifiable. As a result, the market equilibrium is biased towards inefficiently low venture capital support. The capital gains tax becomes especially harmful, as it further impairs advice and causes a first-order welfare loss. Once the capital gains tax is in place, limitations on loss off-set may paradoxically contribute to higher quality of venture capital finance and welfare. Subsidies to physical investment in VC-backed start-ups are detrimental in our framework.

This paper studies the effect of investor-specific differential dividend taxation on the dynamics of equilibrium security prices and allocations. In order to deal with the inherent Pareto inefficiency of such an equilibrium as well as the preclusion of tax arbitrage, we construct a continuous-time equilibrium via a representative investor with state-dependent utility. Investors differ in their pricing of risk, inducing investor-specific consumption-based CAPMs, with differential taxation appearing as an additional factor. The interest rate, stock price, and consumption dynamics are also impacted. Under logarithmic preferences, risk is transferred from the higher-taxed to the lower-taxed investor, and the interest rate decreases to counteract extra precautionary savings against this suboptimally shared risk. Numerical analysis reveals further tax rate, time-to-horizon, and dividend risk effects on equilibrium quantities. For most wealth allocations, the stock return volatility is increased above the no-tax benchmark.

Market discipline is an article of faith among financial economists, and the use of market discipline as a regulatory tool is gaining credibility. Effective market discipline involves two distinct components: security holders' ability to accurately assess the condition of a firm (monitoring) and their ability to cause subsequent managerial actions to reflect those assessments (influence). Substantial evidence supports the existence of market monitoring. However, the existing evidence about market influence involves relatively rare events such as management turnover. This paper seeks evidence that U.S. bank holding companies' security price changes reliably influence subsequent managerial actions. Although we identify some patterns consistent with beneficial market influences, our methodology does not provide strong evidence that stock or (especially) bond investors regularly influence managerial actions. Day-to-day market influence remains, for the moment, more a matter of faith than of empirical evidence.