Knowledge that Transforms

The paper by B. Chowdhry and J. Howe examines if production delocalization can play a useful role for corporate exchange rate risk management. Such “operational hedging” transfers the production costs into the foreign currency area and may thus reduce the operating exposure of a firm. The authors claim that operational hedging emerges only if a firm faces a combination of exchange rate and demand uncertainty. Exchange rate uncertainty alone cannot justify production delocalization because it can be hedged with foreign exchange instruments. Only the interaction of exchange rate risk with demand uncertainty can justify delocalization to the extend that market incompleteness prevents insurance of demand risk. The authors derive their conclusions from ad hoc assumptions which lack proper microfoundations. They concede this flaw in a short note on page 4 without fixing it. Two assumptions are in contradiction to microeconomic principles: First, the authors assume that local prices of a multinational firm are fixed in advance and do not change for any given exchange rate change. Second, they assume that the quantity sold in each market and the exchange rate are independent variables. Both assumptions present a dubious starting point and need to be rectified. The following section tries to clean up their model setting. Thereafter, I proceed to the central claim of the paper about the necessity of both demand and exchange rate uncertainty for delocalizations. It turns out this claim cannot be sustained if firm pricing behavior is properly modeled.

In this paper, we reexamine and extend the stochastic volatility model of Stein and Stein (S&S) (1991) where volatility follows a mean–reverting Ornstein–Uhlenbeck process. Using Fourier inversion techniques we are able to allow for correlation between instantaneous volatilities and the underlying stock returns. A closed-form pricing solution for European options is derived and some numerical examples are given. In addition, we discuss the boundary behaviour of the instantaneous volatility at v(t) = 0 and show that S&S do not work with an absolute value process of volatility.

This paper argues that in the fundamental subject of financial risk analysis, some valuable lessons may be drawn from insurance. The probability of ruin, defined as a first passage time, carries a dynamic element whose absence in Value at Risk is one liability, among others. Extreme value theory, which has been successfully applied to insurance shortly after it was introduced in probability, may offer a coherent framework for analyzing the extreme moves such as the ones observed in recent foreign exchange and financial crises. Lastly, we show that the genuine hazards generated by global capital markets and illustrated by the events of summer 1998, generate a market incompleteness that existing models of defaultable bonds do not fully address. In contrast, the long experience of risk premium analysis in the insurance and reinsurance industry, as well as the existence of historical data on natural disasters, render the valuation of catastrophe bonds less perilous than that of defaultable bonds.

The pricing of derivative securities in the presence of market frictions has always been a question of fundamental importance. The reason is twofold: market frictions are present in numerous practical applications and, in such settings, the classical valuation theories break down entirely. Examples of market frictions include among others, transaction costs, non-traded assets and portfolio constraints. Alternative valuation criteria have been proposed and a variety of methods have been developed in order to define coherent derivative prices and, ultimately, to specify the hedging strategies. Three main valuation methods have been developed up to date: the superreplication approach, the imperfect-replication method and the utility maximization theory. The super-replication approach looks for hedging strategies that super-replicate, instead of replicating exactly, the payoff of the derivative security. The motivation for such a pricing mechanism comes from the fact that exact replication might result in an infinite derivative price, like for example in the presence of transaction costs (Soner et al., 1995). The imperfect replication method allows

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We present a consumption‐based model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long‐horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much of the history of stock prices from consumption data. It explains the short‐and long‐run equity premium puzzles despite a low and constant risk‐free rate. The results are essentially the same whether we model stocks as a claim to the consumption stream or as a claim to volatile dividends poorly corelated with consumption. The model is driven by an independently and identically distributed consumption growth process and adds a slow ‐moving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia. Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of long‐run average consumption growth.

In Lazear's model of long‐term incentive contracts, age discrimina‐tion laws barring age‐ based involuntary terminations preclude such contracts, reducing efficiency. Alternatively, such laws may serve as precommitment devices for these contracts, without pre‐venting firms from offering strong financial incentives to induce retirement at specific ages. In this case, age discrimination laws may encourage Lazear contracts, hence increasing efficiency. We assess evidence on these alternative interpretations using variation in state and federal age discrimination laws. The evidence indicates that age discrimination laws steepen age‐earnings profiles for co‐horts entering the labor market, suggesting that these laws encour‐age the use of Lazear contracts.

Do employers and workers underbid prevailing wages if there si unemployment? Do employers take advantage of workers' underbidding by lowering wages? Do employers take advantage of workers underbidding by lowering wages? We hypothesize that under conditions of incomplete labor contracts, wage levels may positively affect workers' propensity to cooperate. This, in turn, may prevent firms from underbidding or accepting the underbidding of workers. Experimental double auctions conducted for the purpose of examinating these hypotheses yield the following results: (i) Workers' underbidding is very frequent, but employers refuse to accept workers' low wage offers in markets with complete labor contracts, employes accept and actively enforce wages close to the competitive level. (ii) Workers' effort is positively related to the wage level. Therefore over their effort level. This holds true even in the presence of explicit performance incentives.

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Common culture and common language facilitate trade between people. Minorities have incentives to become assimilated and to learn the majority language so that they have a larger pool of potential trading partners. The value of assimilation is larger to someone from a small minority than to one from a large minority group. When a society has a very large majority of individuals from one culture, individuals from minority groups will be assimilated more quickly. Assimilation is less likely when an immigrant's native culture and language is broadly represented in his new country. Also, when governments protect minority interests directly, incentives to be assimilated into the majority culture are reduced. Both factors may explain the recent rise in multiculturalism. Individuals do not properly internalize the social value of assimilation and ignore the benefits others receive when they learn the majority language and become assimilated. In a pluralistic society, a government policy that encourages diverse cultural immigration over concentrated immigration is likely to increase the welfare of the population. In the absence of strong offsetting effects, policies which encourage multi- culturalism reduce the amount of trade and have adverse welfare consequences. Conversely, policies that subsidize assimilation and the acquisition of majority language skills can be socially beneficial. The theory is tested and confirmed by examining U.S. Census data, which reveals that the likelihood that an immigrant will learn English is inversely related to the proportion of the local population that speaks his or her native language.