We study the interaction between relationship banking and short-term arm’s length activities of banks, called trading. We show that a bank can use the franchise value of its relationships to expand the scale of trading, but may allocate too much capital to trading ex post, compromising its ability to build relationships ex ante. This effect is reinforced when trading is used for risk shifting. Overall, combining relationship banking and trading offers benefits under small-scale trading, but distortions may dominate when trading is unbridled. This suggests that trading by banks, while benign historically, might be distortive with deeper financial markets.

Popular investment advice recommends that stock/bond and stock/wealth ratios should rise with investor risk tolerance and investment horizon respectively, prescriptions that are difficult to reconcile with the simple mean-variance model. We show that extending the mean-variance model to include human capital, without any other modifications, can simultaneously justify both recommendations, so long as the correlation between labour income and stock returns falls within a range determined by market and investor-specific parameters. Aggregate labour income data from 11 countries generally satisfy this requirement, as do plausible individual income processes. We also consider the implications of human capital for the optimal bond/wealth ratio over the investment horizon, and examine the sensitivity of the stock/bond mix to the volatility of labour income.

This article examines the contribution of hedging to firm value and the cost of hedging in a unified framework. Optimal hedging and firm value are explicitly linked to firm risk, the type of debt covenants and the relative priority of the hedging contract. It is shown that in some cases hedging is possible only if the counterparty to the forward contract also holds a significant portion of the debt. Also, the spread in the hedging contract reduces the optimal amount of hedging to less than the minimum-variance hedge ratio. Among other results this article elucidates why some firms hedge using forward contracts while other firms hedge in the futures markets, as well as why higher priority forward contracts are more efficient hedging vehicles.

This paper focuses on pricing and hedging options on a zero-coupon bond in a Heath-Jarrow-Morton (1992) framework when the value and/or functional form of forward interest rates volatility is unknown, but is assumed to lie between two fixed values. Due to the link existing between the drift and the diffusion coefficients of the forward rates in the Heath, Jarrow and Morton framework, this is equivalent to hedging and pricing the option when the underlying interest rate model is unknown. We show that a continuous range of option prices consistent with no arbitrage exist. This range is bounded by the smallest upper-hedging strategy and the largest lower-hedging strategy prices, which are characterized as the solutions of two non-linear partial differential equations. We also discuss several pricing and hedging illustrations.

This paper examines the relation between information differences across investors (i.e., information asymmetry) and the cost of capital and establishes that with perfect competition information asymmetry makes no difference. Instead, a firm’s cost of capital is governed solely by the average precision of investors’ information. With imperfect competition, however, information asymmetry affects the cost of capital even after controlling for investors’ average precision. In other words, the capital market’s degree of competition plays a critical role for the relation between information asymmetry and the cost of capital. This point is important to empirical research in finance and accounting.

During 2004 and 2005, long-horizon interest rates fell sharply in major international government bond markets (Greenspan's “conundrum”). This common fall mainly reflected lower long real rates. To investigate possible causes, the authors apply a no-arbitrage affine modeling framework to understanding the UK real term structure. The authors find that time-varying term premia are important in explaining movements in long real forward rates. And, although there is evidence that long-horizon expected short real rates declined over the conundrum period, the authors’ results suggest that lower term premia played the dominant role. This could be consistent with the so-called “search for yield” and excess liquidity explanations for the conundrum.

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.

In the USA, state-level exemptions determine the amount of property that individuals can protect from creditor liquidation during the debt settlement process. We exploit within-metropolitan statistical area variation in personal bankruptcy exemptions created by state borders and a stacked regression approach to identify the spillover effects of these laws on business credit extended to small firms. Subsequent to exemption increases, we find a reduction of 1–2 percent in originations of business credit. The effect is strongest for the smallest firms, which are more financially constrained. We provide household-level evidence that both business debt and personal debt decline for borrowers whose home equity becomes covered by the exemption, suggesting an overall decrease in credit availability for small businesses. As a result, increases in exemptions lead to fewer small establishments and lower employment, especially in industries dependent on external finance, suggesting that negative real economic effects occur via a credit market channel.

We introduce a novel strategy to predict monthly equity premia that is based on extracted news from more than 700,000 newspaper articles, which were published in The New York Times and Washington Post between 1980 and 2018. We propose a flexible data-adaptive switching approach to map a large set of different news-topics into forecasts of aggregate stock returns. The information that is embedded in our extracted news is not captured by established economic predictors. Compared with the prevailing historical mean between 1999 and 2018, we find large out-of-sample (OOS) gains with an ROOS2 of 6.52% and sizeable utility gains for a mean–variance investor. The empirical results indicate that geopolitical news are at times more valuable than economic news to predict the equity premium and we also find that forecasting gains arise in down markets.

We examine the effect of say on pay regulation in the UK. Consistent with the view that shareholders regard say on pay as a value-creating mechanism, the regulation’s announcement triggered a positive stock price reaction at firms with weak penalties for poor performance. UK firms responded to negative say on pay voting outcomes by removing controversial CEO pay practices criticized as rewards for failure (e.g., generous severance contracts) and increasing the sensitivity of pay to poor realizations of performance.