Knowledge that Transforms

It appears that volatility in equity markets is asymmetric: returns and conditional volatility are negatively correlated. We provide a unified framework to simultaneously investigate asymmetric volatility at the firm and the market level and to examine two potential explanations of the asymmetry: leverage effects and time-varying risk premiums. Our empirical application uses the market portfolio and portfolios with different leverage constructed from Nikkei 225 stocks, extending the empirical evidence on asymmetry to Japanese stocks. Although volatility asymmetry is present and significant at the market and the portfolio levels, its source differs across portfolios. We find that it is important to include leverage ratios in the volatility dynamics but that their economic effects are mostly dwarfed by the volatility feedback mechanism. Volatility feedback is enhanced by a phenomenon that we term covariance asymmetry: conditional covariances with the market increase only significantly following negative market news. We do not find significant asymmetries in conditional betas.

We show that concentrating bank regulation on bank capital ratios may be ineffective in controlling risk taking. We propose, instead, a more direct mechanism of influencing bank risk-taking incentives, in which the FDIC insurance premium scheme incorporates incentive features of top-management compensation. With this scheme, we show that bank owners choose an optimal management compensation structure that induces first-best value-maximizing investment choices by a bank's management. We explicitly characterize the parameters of the optimal management compensation structure and the fairly priced FDIC insurance premium in the presence of a single or multiple sources of agency problems.

Recent empirical evidence suggests that expected stock returns are weakly, or even negatively, related to the volatility of stock returns at the market level, and that this relation varies substantially over time. This evidence contradicts the apparently reliable intuition that risk and return are positively related and that stock market volatility is a good proxy for risk. This paper investigates the relation between volatility and expected returns in a general equilibrium, exchange economy. A relatively simple model, estimated using aggregate consumption data, is able to duplicate the salient features of the observed expected return/volatility relation. The key features of the model are the existence of two regimes with different consumption growth processes and time-varying correlations between stock returns and the marginal rate of substitution; thus inducing variability in the short-run relation between expected returns and volatility and a weakening of the long-run relation. These results highlight the perils of relying on intuition from static models. They also have important implications for the empirical modeling of returns.

The unique characteristics of bank loans emerge endogenously to enhance efficiency in a model of renegotiation between a borrower and a lender in which there is the potential for moral hazard on each side of the relationship. Firm risk is endogenous and renegotiated interest rates on the debt need not be monotone in firm risk. The initial terms of the debt are not set to price default risk but rather are set to efficiently balance bargaining power in later renegotiation. Loan pricing may be nonlinear, involving initial transfers either from the borrower to the bank or from the bank to the borrower.