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.

The strength of economic theory is that it can look at the hypothetical rather than merely ex-post rationalize observed behavior. In particular, it can ask the 'what if' question of how changes in model parameters might affect efficiency and social welfare. Based on the answer, it can then suggest welfare-improving policy measures in situations in which privately optimal outcomes are socially inefficient.

This paper studies financial intermediation in a general equilibrium overlapping generations model. Indivisible investment projects combine with informational imperfections to create a (hidden action) moral hazard problem and introduce a role for third-party monitoring. Agency costs at the intermediary level are also considered. Under some conditions, monitors can be viewed as banks facing a non-trivial portfolio diversification problem. Equilibria are derived in which a large nationwide bank coexists with a number of community-regional banks, a structure of strong empirical relevance. Policies such as a mandatory reserve requirement are shown to have substantial effects on the levels of investment in the economy.

Using merger announcements and applying methods from computational linguistics we find strong evidence that stock prices underreact to information in financial media. A one standard deviation increase in the media-implied probability of merger completion increases the subsequent 12-day return of a long-short merger strategy by 1.2 percentage points. Filtering out the 28% of announced deals with the lowest media-implied completion probability increases the annualized alpha from merger arbitrage by 9.3 percentage points. Our results are particularly pronounced when high-yield spreads are large and on days when only few merger deals are announced.

We develop an analytical solution to the dynamic portfolio choice problem of an investor with power utility defined over wealth at a finite horizon, who faces a time-varying investment opportunity set, parameterized using a flexible vector autoregression. We apply this framework to study the horizon effects in the allocations of equity-only investors, who hold a mix of value and growth indices, and a more general investor, who also has access to Treasury bills and bonds. We find that the mean allocation of equity-only investors is heavily tilted towards value stocks at short-horizons, but the magnitude of this tilt declines dramatically with the investment horizon, implying that growth is less risky than value at long horizons. Investors with access to bills and bonds exhibit similar behavior, when value and growth tilts are computed relative to the total equity allocation of the portfolio. However, after accounting for the propensity of these investors to increase their total equity allocation as the horizon increases, the mean value tilt of the optimal allocation is shown to be positive and stable across time.

Value-at-risk methods which employ a linear (“delta only”) approximation to the relation between instrument values and the underlying risk factors are unlikely to be robust when applied to portfolios containing non-linear contracts such as options. The most widely used alternative to the delta-only approach involves revaluing each contract for a large number of simulated values of the underlying factors. In this paper we explore an alternative approach which uses a quadratic approximation to the relation between asset values and the risk factors. This method (i) is likely to be better adapted than the linear method to the problem of assessing risk in portfolios containing non-linear assets, (ii) is less computationally intensive than simulation using full-revaluation and (iii) in common with the delta-only method, operates at the level of portfolio characteristics (deltas and gammas) rather than individual instruments.

Defined benefit pension and health care plans are important for firm leverage around the world. While consolidating off-balance sheet post-retirement plans increases effective leverage by 32%, firms reduce their level of regular debt by only 22 cents for every dollar of projected benefit obligation, yielding overall 23% higher total leverage of plan sponsors compared with similar firms without post-retirement plans. The most important driver of substitution rates between regular debt and post-retirement obligations is rule of law, followed by labor market freedom and taxes. In contrast, pension guarantee funds and priority of unfunded pension obligations are less important for substitution rates.

This paper develops a real options model in which firms may use the timing of their initial public offerings (IPOs) to signal the quality of their investment prospects to outside investors. When adverse selection is more relevant (cold markets), firms with better investment prospects accelerate their IPO relative to their perfect information benchmark to reveal their type to outside investors. When adverse selection is less relevant (hot markets), all firms issue simultaneously, issuers are younger on average, and IPO timing is uninformative. An extension with multiple signals and the empirical evidence show that better ranked firms are younger, issue a lower fraction of shares, and underprice more during cold markets, and that issuers are younger on average during hot markets.

This paper analyzes the effect of uncertainty about the mean return on the risky asset on the portfolio decisions of an investor who has a long investment horizon. Building on the earlier work of Detemple (1986), Dothan and Feldman (1986), and Gennotte (1986), it is shown that the possibility of future learning about the mean return on the risky asset induces the investor to take a larger or smaller position in the risky asset than she would if there were no learning, the direction of the effect depending on whether the investor is more or less risk tolerant than the logarithmic investor whose portfolio decisions are unaffected by the possibility of future learning. Numerical calculations show that uncertainty about the mean return on the market portfolio has a significant effect on the portfolio decision of an investor with a 20 year horizon if her assessment of the market risk premium is based solely on the Ibbotson and Sinquefield (1995) data.