Knowledge that Transforms

Abstract 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. JEL Classification codes: G2 L2

Abstract We present a continuous-time asset pricing model of the levered firm where shareholders select not only the timing but also the form of abandonment. Shareholders can walk out of the firm either by (i) defaulting on their debt obligations or (ii) selling their shares to alternative operators of, the technologies, as in a corporation sale . The structural model relates shareholders' ex-post choice to both technological and financial factors. Considering that operators' technological supremacy is not universal, we obtain that whereas default necessarily involves an inefficient timing of ownership transfer, corporation sales do not. Then, the likelihood of default being chosen instead of a corporation sale increases with (i) the degree of leverage displayed by the firm and (ii) its technological supremacy. By ignoring corporation sales, existing defaultable bond pricing models have thus a tendency to exaggerate risk premia and underestimate the borrowing ability (debt capacity) of firms.

Abstract This paper provides a survey of existing literature on portfolio allocations in conventional and tax-deferred investment habitats. A long-standing puzzle in this literature has been the dissonance between the theoretical prediction of tax-efficient portfolio choices and observed portfolio allocations. I clarify this prediction and offer a different perspective by emphasizing the importance of uninsurable labor income risk and restrictions on accessibility of tax-deferred assets. I identify the key factors in dual-habitat portfolio decisions and highlight the necessary ingredients for producing non-tax-efficient, or precautionary, allocations. JEL classification codes: D12, G11, H24.

Abstract 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. JEL classification numbers: G21, G33

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

Abstract 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. JEL Classification codes: E43, G12, D92, D80, D51.

Global turnover in foreign exchange markets averaged $1.2 trillion per day according to the most recent estimates available from the Bank for International Settlements. 1 Yet, cross-border trade of goods and services accounts for less than 5 percent of the total trading. While it is difficult to get precise estimates on hedging, roughly 20 percent of total trading is aimed at hedging against future exchange rate changes. The remaining roughly 75 percent of total turnover in global foreign exchange markets is believed to be related to short or long term exchange rate speculation. The large fraction of global turnover in currency markets that is unrelated to trade or hedging has lead economists and policy markets to the conjecture that speculation is responsible for the perceived recent increase in volatility in foreign exchange markets. Several economists, most prominently Nobel Laureate Dr. James Tobin, have advocated levying a tax (a "Tobin tax") on foreign exchange transactions to reduce volatility induced by exchange rate speculation. Recently, several European countries spearheaded by France have debated a proposed legislation to impose a tax on currency transactions. 2 However, to date, there is no strong empirical evidence that an increase in transactions costs (which would be the result of a Tobin tax) would significantly dampen volatility. On the contrary, This is the first piece of legislation in the world that would implement a Tobin-type tax. Belgium passed similar legislation in March, 2002, and several other European Union member countries have debated a Tobin tax. See www.currencytax.org.

Abstract This paper analyzes inspection and closure policies of a bank, and the strategic reaction of its managers/shareholders when they can (costly) manipulate the information available to the regulator. We derive optimal intervention policy, and analyze its effect on managerial strategies. Regulatory intervention may induce shareholders to manipulate the information available to the regulator in order to avoid intervention and closure, and we find that these incentives to manipulate information may increase with tighter capital requirements. Finally we show that, in order to avoid manipulation by the banker, some degree of forbearance in closure may be ex ante optimal. JEL classification codes: G21, G28