Financial Market Frictions

Defined simply as anything that interferes with trade, financial market frictions can exist even in efficient markets. Understanding financial market frictions is important, this article argues, because they generate real costs to investors, because they generate business opportunities, and because they change over time. Financial market frictions depend in part on market structure. Market structure tends to evolve over time, as trading volume increases, from low fixed costs and high marginal costs to high fixed costs and low marginal costs. To help identify the best means of reducing market frictions costs, the authors classify and discuss five primary categories of frictions: transactions costs, taxes and regulations, asset indivisibility, nontraded assets, and agency and information problems. Looking for evidence of how frictions influence market participants behavior, the authors not only review the economic literature but also conduct an empirical exercise to illustrate and quantify frictions impact on investors risk-return trade-off. Their results show that market frictions impose utility costs on investors by making preferable investment portfolios unattainable. Their findings and other academic studies also suggest that investors who ignore market frictions compound the harm done by the frictions themselves

Asset allocation and section 529 plans

Previous research has concluded that prespecified asset allocations used by many Section 529 college savings plans are suboptimal. We extend this research to show that though it may be true, it is true for reasons other than those asserted in previous research. In addition, it tends to deflect attention from other investment options and strategies.Investments ; Saving and investment

Merchant acquirers and payment card processors: a look inside the black box

Each year, hundreds of millions of credit and debit cardholders make billions of transactions worth trillions of dollars. Yet few consumers are aware that such transactions travel through, and are made possible by a highly evolved group of intermediaries that sign up merchants to accept cards, handle card transactions, manage the dispute-resolution process, and, along with regulatory agencies, set rules that govern card transactions. ; This article demystifies the “Black Box” of the transactions process for payment cards. After describing a simple transaction with a private-label card, the author then considers the complications introduced by general-purpose cards, such as Visa and MasterCard, emphasizing the key roles of merchant acquirers and card processors. ; Merchant acquirers, who sign up merchants to accept cards and who provide or arrange for processing, bear most of the risk of loss if merchants fail to make good on credit transactions disputed by customers. To guard against such losses, acquirers carefully evaluate the credit quality of merchants seeking or using the acquirers’ services. ; The article delineates some of the risk factors associated with specific industries, merchant types, and transactions that influence the price merchants pay for acquirers’ services. Finally, the article discusses some ways that merchant acquirers manage risk, especially the risk of fraud.Payment systems ; Credit cards ; Risk

Direct investments in securities: A primer

Direct investment plans (commonly known as DRIPs) let investors bypass traditional investment channels and avoid problems such as high transactions costs and the relatively large dollar amounts necessary to purchase certain assets. While no one expects these plans to answer all of the modern investor's needs, DRIPs probably appeal to the buy-and-hold clientele seeking the lowest possible transactions costs. ; This article discusses DRIPs, describing how the financial services industry has evolved to meet the needs of the small investor. The author identifies the remaining limitations on this sort of investment, noting that mutual funds continue to offer convenience and unmatched diversification for small accounts. He then presents reasons why companies might offer DRIPs. For example, companies that face political or regulatory scrutiny may want a broad, stable ownership base. Such shareholders also tend to vote with management, offering potential as a takeover defense. Finally, a broad ownership base provides opportunities for cross-selling. ; The article also identifies empirical differences between companies that offer DRIPs and those that do not. The analysis shows that large companies, more mature companies, and companies in industries that are subject to relatively high levels of regulation are more likely to offer the plans. ; Finally, the discussion speculates about the future of direct investments. One obvious tool for DRIP investors is the Internet. Broker-run DRIPs provide another evolutionary direction.Investments ; Saving and investment

Analyzing imputed financial data: a new approach to cluster analysis

The authors introduce a novel statistical modeling technique to cluster analysis and apply it to financial data. Their two main goals are to handle missing data and to find homogeneous groups within the data. Their approach is flexible and handles large and complex data structures with missing observations and with quantitative and qualitative measurements. The authors achieve this result by mapping the data to a new structure that is free of distributional assumptions in choosing homogeneous groups of observations. Their new method also provides insight into the number of different categories needed for classifying the data. The authors use this approach to partition a matched sample of stocks. One group offers dividend reinvestment plans, and the other does not. Their method partitions this sample with almost 97 percent accuracy even when using only easily available financial variables. One interpretation of their result is that the misclassified companies are the best candidates either to adopt a dividend reinvestment plan (if they have none) or to abandon one (if they currently offer one). The authors offer other suggestions for applications in the field of finance.

Financial market frictions

Market frictions, which exist even in efficient markets and change over time, impede trade but also offer profit opportunities. To provide a framework for understanding market frictions, the authors classify frictions into five categories.Financial markets

Capital forbearance and thrifts: an ex post examination of regulatory gambling

This paper estimates the losses embedded in the capital positions of the 996 FSLIC-insured savings and loan institutions that did not meet capital standards at the end of the 1970s. We compare the estimated cost of resolving the insolvencies of these institutions at the end of the 1970s with the actual failure-resolution costs for those that were closed by July 3 1, 1992, and the projected resolution costs for the remaining thrifts that are likely to be closed. Our results show that even when one considers only the direct costs associated with delayed closure of economically failed thrifts, these costs significantly exceed reasonable estimates of the cost of prompt failure resolution.Savings and loan associations

Understanding 401(k) plans

Questions about the future of the Social Security system continue to surface. As a result, interest in employer-sponsored retirement plans and other retirement investment options increases. But the restrictions and rules associated with various defined benefit plans such as 401(k), 403 (b), and 457 plans can be confusing, and these plans have risks of their own. The authors explore these plans and explain the need to view retirement savings as only one part of a portfolio.

Uncertainty Quantification for Airfoil Icing using Polynomial Chaos Expansions

The formation and accretion of ice on the leading edge of a wing can be detrimental to airplane performance. Complicating this reality is the fact that even a small amount of uncertainty in the shape of the accreted ice may result in a large amount of uncertainty in aerodynamic performance metrics (e.g., stall angle of attack). The main focus of this work concerns using the techniques of Polynomial Chaos Expansions (PCE) to quantify icing uncertainty much more quickly than traditional methods (e.g., Monte Carlo). First, we present a brief survey of the literature concerning the physics of wing icing, with the intention of giving a certain amount of intuition for the physical process. Next, we give a brief overview of the background theory of PCE. Finally, we compare the results of Monte Carlo simulations to PCE-based uncertainty quantification for several different airfoil icing scenarios. The results are in good agreement and confirm that PCE methods are much more efficient for the canonical airfoil icing uncertainty quantification problem than Monte Carlo methods.Comment: Submitted and under review for the AIAA Journal of Aircraft and 2015 AIAA Conferenc

Expected returns to stock investments by angel investors in groups

Angel investors invest billions of dollars in thousands of entrepreneurial projects annually, far more than the number of firms that obtain venture capital. Previous research has calculated realized internal rates of return on angel investments, but empirical estimates of expected returns have not yet been produced. Although calculations of realized returns are a valuable contribution, expected returns, rather than realized returns, drive investment decisions. We use a new data set and statistical framework to produce the first empirical estimates of expected returns on angel investments. We also allow for the time value of money, which previous research has typically ignored. Our sample of 588 investments spans the 1972–2007 period and contains 419 exited investments. We conduct extensive tests to explore potential bias in the data set and conclude that the evidence in favor of bias is tenuous at best. Our results suggest that angel investors in groups can expect to earn returns that are on the order of returns on venture capital investments. Estimated net returns are about 70 percent in excess of the riskless rate per year for an average holding period of 3.67 years. This estimate is reasonable compared to Cochrane's (2005) estimate of 59 percent per year for venture capital investments, which tend to be in lower-variance, later-stage projects. Returns have a large variance and are heavily skewed, with many losses and occasional extraordinarily high returns.