Extracting Inflation from Stock Returns to Test Purchasing Power Parity

Relative purchasing power parity (PPP) holds for pure price inflations, which affect prices of all goods and services by the same proportion, while leaving relative prices unchanged. Pure price inflations also affect nominal returns of all traded financial assets by exactly the same amount. Recognizing that relative PPP may not hold for the official inflation data constructed from commodity price indices because of relative price changes and other frictions that cause prices to be "sticky," we provide a novel method for extracting a proxy for realized pure price inflation from stock returns. We find strong support for relative PPP in the short run using the extracted inflation measures

Extracting Inflation from Stock Returns to Test Purchasing Power Parity

Relative purchasing power parity (PPP) holds for pure price inflations, which affect prices of all goods and services by the same proportion, while leaving relative prices unchanged. Pure price inflations also affect nominal returns of all traded financial assets by exactly the same amount. Recognizing that relative PPP may not hold for the official inflation data constructed from commodity price indices because of relative price changes and other frictions that cause prices to be "sticky," we provide a novel method for extracting a proxy for realized pure price inflation from stock returns. We find strong support for relative PPP in the short run using the extracted inflation measures

Defaults and Interest Rates in International Lending

Since lenders cannot observe the riskiness of the projects borrowers could choose, interest rates alone cannot be used as an instrument to discipline the borrowers. A credible threat to exclude borrowers who default more than a certain number of times from participating in the capital markets makes international debt contracts incentive compatible. Larger borrowers, since they get fewer chances to default, choose safer proejcts and are therefore charged smaller interest rates. Also, borrowers, after each successive default swtich to safer and safer projects which may result in smaller and smaller interest rates. This paper provides empirical evidence supporting these two predictions

Exchange Risk Management and Corporate Capital Structure

We analyze hedging policies for a corporation that generates a foreign currency cash flow that is not known with certainty. We first show that if investors care about real rather than nominal cash flows, there are no "free lunches" due to the Siegal Paradox. THe profile of cash flows that accrue to the equity holders of the firm in various states is completely dtermined by the contractual value of the firm's foregin currency liability could always be chosen to be a foward contract to deliver the foreign currency. We obtain an intriguing result that the probability of bankruptcy for a film that attempts to minimize this probability is lower when htere is some uncertainty in the exchange rates than when there is no uncertainty in the exchange rates: the firm reduces the probability of bankruptcy by borrowing more than its financing needs through foregin currency borrowing alone and by investing the excess funds in domestic risk free securities. Our result provides a reationale for why firms amy choose not to invoice their products in a currency that has no inflation variability; this may also explalin why forms choose to write contracts in nominal rather than real terms

International Debt Crisis and the Prices of Options of Bank Stocks

Modelling the stock price processes of banks with large exposures to Latin American debt as a combination of diffusion and jump processes leads to a no-arbitrage pricing restriction which can be used to infer the implied market prices of Latin American debt