Knowledge that Transforms

Abstract The paper shows that mispriced deposit insurance and capital regulation were of second-order importance in determining the capital structure of large U.S. and European banks during 1991 to 2004. Instead, standard cross-sectional determinants of non-financial firms’ leverage carry over to banks, except for banks whose capital ratio is close to the regulatory minimum. Consistent with a reduced role of deposit insurance, we document a shift in banks’ liability structure away from deposits towards non-deposit liabilities. We find that unobserved time-invariant bank fixed-effects are ultimately the most important determinant of banks’ capital structures and that banks’ leverage converges to bank specific, time-invariant targets.

Abstract We examine empirically the response of bond returns and their volatility to good and bad macroeconomic news during expansions and recessions. We find that macroeconomic announcements are most important when they contain bad news for bond returns in expansions and, to a lesser extent, good news in contractions. In expansions, the bond market responds most strongly to bad news in non-farm payrolls, while in recessions good news about inflation is relatively more important. We also document that macroeconomic news impacts the volatility of bond returns at all maturities by increasing jump intensities and altering the jump size distribution.

Abstract We study high-frequency exchange rates over the period 1993–2008. Based on the recent literature on volatility and liquidity risk premia, we use a factor model to capture linear and non-linear linkages between currencies, stock and bond markets as well as proxies for market volatility and liquidity. We document that the Swiss franc and Japanese yen appreciate against the US dollar when US stock prices decrease and US bond prices and FX volatility increase. These safe haven properties materialise over different time granularities (from a few hours to several days) and non-linearly with the volatility factor and during crises. The latter effects were particularly discernible for the yen during the recent financial crisis.

Abstract We test the limits of arbitrage argument for the survival of irrationality-induced financial anomalies by sorting securities on their individual residual variability as a proxy for idiosyncratic risk – a commonly asserted limit to arbitrage – and comparing the strength of anomalous returns in low versus high residual variability portfolios. We find no support for the limits of arbitrage argument to explain undervaluation anomalies (small value stocks, value stocks generally, recent winners, and positive earnings surprises) but strong support for the limits of arbitrage argument to explain overvaluation anomalies (small growth stocks, growth stocks generally, recent losers, and negative earnings surprises). Other tests also fail to support the limits of arbitrage argument for the survival of overvaluation anomalies and suggest that at least some of the factor premiums for size, book-to-market, and momentum are unrelated to irrationality protected by limits to arbitrage.

Abstract This paper studies the impact of financing constraints in patent races. We develop a model of optimal contracting where firms finance their R&D expenditures with an investor who cannot verify their effort. In equilibrium, firms are more likely to win the more cash and assets they hold prior to the race, and the less cash and assets their rivals hold prior to the race. Evidence from US pharmaceutical patents awarded between 1975 and 1999 supports our theoretical predictions.

Abstract We consider mean-variance portfolio choice of a robust investor. The investor receives advice from J experts, each with a different prior for expected returns and risk, and follows a min-max portfolio strategy. The robust investor endogenously combines the experts' estimates. When experts agree on the main return generating factors, the investor relies on the advice of the expert with the strongest prior. Dispersed advice leads to averaging of the alternative estimates. The robust investor is likely to outperform alternative strategies. The theoretical analysis is supported by numerical simulations for the 25 Fama-French portfolios and for 81 European country and value portfolios.

Abstract We analyze the role of bankers on the boards of German non-financial companies for the period from 1994 to 2005. We find that banks that are represented on a firm's board promote their own business as lenders and as M&A advisors. They also seem to act as financial experts who help firms to obtain funding, especially in difficult times. We find little evidence that bankers monitor management and suggest that bankers on the board cause a decline in the valuations of non-financial firms. Banks’ equity ownership declined sharply during our sample period and the German financial system lost some of its formerly distinctive features.

Abstract We propose a model for stock price dynamics that explicitly incorporates random waiting times between trades, also known as duration, and show how option prices can be calculated using this model. We use ultra-high-frequency data for blue-chip companies to motivate a particular choice of waiting-time distribution and then calibrate risk-neutral parameters from options data. We also show that the convexity commonly observed in implied volatilities may be explained by the presence of duration between trades. Furthermore, we find that, ceteris paribus, implied volatility decreases in the presence of longer durations, a result consistent with the findings of Engle (2000) and Dufour and Engle (2000) which demonstrates the relationship between levels of activity and volatility for stock prices. Finally, by directly employing information given by time-stamps of trades, our approach provides a direct link between the literature on stochastic time changes and business time (see Clark (1973)) and, at the same time, highlights the link between number and time of arrival of transactions with implied volatility and stochastic volatility models.

Abstract This paper develops a convergence model of the term structure of interest rates in context of entering the European Monetary Union (EMU). Compared to other models developed so far in this field, our model specification ensures convergence of the domestic short-term interest rates to the euro area ones. We achieve this convergence by stating that the spread between domestic and euro short-term interest rate follows the Brownian bridge process. We also develop an econometric counterpart of the theoretical model. To tackle the problem of nonstationarity and nonlinearity of the model, we apply the extended Kalman filter for coefficient estimation.

Abstract The Federal Reserve adjusts the federal funds target rate discretely, causing discontinuity in short-term interest rates. Unlike Poisson jumps, these adjustments are well anticipated by the market. We propose a term structure model that incorporates an anticipated jump component with known arrival times but random jump size. We find that doing so improves the model performance in capturing the term structure behavior. The mean jump sizes extracted from the term structure match the realized target rate changes well. Specification analysis indicates that the jump sizes show strong serial dependence and dependence on the interest-rate factors.