A proposal for impact-adjusted valuation: Critical leverage and execution risk

The practice of valuation by marking-to-market with current trading prices is seriously flawed. Under leverage the problem is particularly dramatic: due to the concave form of market impact, selling always initially causes the expected leverage to increase. There is a critical leverage above which it is impossible to exit a portfolio without leverage going to infinity and bankruptcy becoming likely. Standard risk-management methods give no warning of this problem, which easily occurs for aggressively leveraged positions in illiquid markets. We propose an alternative accounting procedure based on the estimated market impact of liquidation that removes the illusion of profit. This should curb the leverage cycle and contribute to an enhanced stability of financial markets.Comment: 19 pages, 3 figure

Optimal Trade Execution Under Endogenous Pressure to Liquidate: Theory and Numerical Solutions

We study optimal liquidation of a trading position (so-called block order or meta-order) in a market with a linear temporary price impact (Kyle, 1985). We endogenize the pressure to liquidate by introducing a downward drift in the unaffected asset price while simultaneously ruling out short sales. In this setting the liquidation time horizon becomes a stopping time determined endogenously, as part of the optimal strategy. We find that the optimal liquidation strategy is consistent with the square-root law which states that the average price impact per share is proportional to the square root of the size of the meta-order (Bershova and Rakhlin, 2013; Farmer et al., 2013; Donier et al., 2015; T´oth et al., 2016). Mathematically, the Hamilton-Jacobi-Bellman equation of our optimization leads to a severely singular and numerically unstable ordinary differential equation initial value problem. We provide careful analysis of related singular mixed boundary value problems and devise a numerically stable computation strategy by re-introducing time dimension into an otherwise time-homogeneous task

Overleveraging, financial fragility and the banking-macro link : theory and empirical evidence

We investigate consequences of overleveraging and financial-sector stress on real economic activities. When banks become vulnerable, due to high leveraging, and there is a strong feedback between the real and the financial sector, a regime of high financial stress may arise. The vulnerability of the banking system in a high lever- age and a high-stress regime can, through macro feedback effects, result in unstable dynamics. To assess this question empirically, we employ a nonlinear, multi-regime vector autoregression approach (MRVAR), to explore the consequences of instabili- ties arising from regime dependent shocks. We analyze data on industrial production and the IMF Financial Stress Index. In order to assess how output is affected by the individual risk drivers making up the IMF index, we study eight economies - the U.S., Canada, Japan and the UK, and for the four largest euro-zone economies, namely, Germany, France, Italy, and Spain, using Granger-causality and nonlinear impulse-response analysis. Our results strongly suggest that financial-sector stress, exerts a strong, nonlinear influence on economic activity, but that individual risk drivers affect economic activity rather differently across stress regimes and across countries

Deciphering the Macroeconomic Effects of Internal Devaluations in a Monetary Union

We study the macroeconomic effects of internal devaluations undertaken by a periphery of countries belonging to a monetary union. We find that internal devaluations have large and positive output effects in the long run. Through an expectations channel, most of these effects carry over to the short run. Internal devaluations focused on goods markets reforms are generally more powerful in stimulating growth than reforms aimed at moderating wages, but the latter are less deflationary. For a monetary union with a periphery the size of the euro area's, the countries at the periphery benefit from internal devaluations even at the zero lower bound (ZLB) of the nominal interest rate. Nonetheless, when the ZLB binds, a sequencing of reforms that prioritizes labor policies over goods markets reforms might increase the present discounted value of output

Research update, Fall 2014

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The effect of cash injections: evidence from the 1980s farm debt crisis

What is the effect of cash injections during financial crises? Exploiting county-level variation arising from random weather shocks during the 1980s Farm Debt Crisis, we analyze and measure the effect of local weather-driven cash flow shocks on the real and financial sector. We show that such cash flow shocks have significant impact on a host of economic outcomes, including land values, loan delinquency rates, the probability of bank failure, employment, and wages. Estimates of the effect of local cash flow shocks on county income levels during the financial crisis yield a multiplier of 1.63

Research update, Fall 2015

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International sanctions and limits of Lerner Symmetry

After a wave of globalization, trade wars and financial sanctions again become frequent tools of international policymaking, leading to an increased interest in the consequences and effectiveness of international sanctions. Itskhoki and Mukhin (2022b) show that Lerner symmetry provides an important benchmark with import and export sanctions equivalent in terms of their effects on allocations and welfare. This abstracts from several practical issues, including the timing of sanctions, interactions between trade and financial restrictions, and the effects of sanctions on the financial sector. We incorporate these features to study their implications and emphasize points of departure from Lerner symmetry

Sticky Leverage

We develop a tractable general equilibrium model that captures the interplay between nominal long-term corporate debt, inflation, and real aggregates. We show that unanticipated inflation changes the real burden of debt and, more significantly, leads to a debt overhang that distorts future investment and production decisions. For these effects to be both large and very persistent, it is essential that debt maturity exceeds one period. We also show that interest rate rules can help stabilize our economy