Government guarantees on pension fund returns

This report reviews defined contribution pension return guarantees typically made by governments in connection with pension privatizations. Finance theory related to the pricing of options provides a unifying framework for evaluating the cost of these guarantees. The report considers two types of guarantees on the rate of return earned by an individual pension fund: a guarantee of a fixed minimum rate of return; and a guarantee of a minimum rate of return that is set relative to the performance of other pension funds. A minimum pension benefit guarantee for a participant in a mandatory defined contribution pension plan is also discussed. Costs for each of these guarantees are illustrated using typical parameter values.Banks&Banking Reform,Insurance&Risk Mitigation,Insurance Law,Economic Theory&Research,Economic Stabilization

Bank deposit insurance and business cycles: controlling the volatility of risk-based premiums

Proposals to make deposit insurance risk-based need to consider how premiums would fluctuate over the business cycle. This paper derives a new deposit insurance contract that has the following three features: 1) it is fairly priced in the sense that the insurer conveys no subsidy to the bank; 2) the insurance rate can be made as stable as desired by lengthening the "average" maturity of the contract; 3) the rate can be frequently updated as new information regarding the bank's financial condition is obtained. These characteristics are achieved with a contract that is a combination of several long-term ones whose contract intervals partially overlap. Relative to a standard, short-term contract, this "moving average" contract reduces the volatility of a bank's insurance rates and avoids payment of excessively high premiums during times of financial distress. ; Estimates of fair insurance rates under such a contract are presented for 42 banks based on data over the period 1987 to 1996. While lengthening the average maturity of the contract reduces the volatility of insurance rates, it also increases the average level of rates since the insurer requires a greater premium for systemic risk. The paper also finds that the distribution of fair insurance rates across banks is skewed, with most banks paying relatively low rates and a small minority of banks paying much higher ones.Risk management ; Deposit insurance

Serial Correlation of Asset Returns and Optimal Portfolios for the Long and Short Term

Optimal portfolios differ according to the length of time they are held without being rebalanced. For the case in which asset returns are identically and independently distributed, it has been shown that optimal portfolios become less diversified as the holding period lengthens.We show that the anti-diversification result does not obtain when asset returns are serially correlated, and examine properties of asymptotic portfolios for the case where the short term interest rate, although known at each moment of time, may change unpredictably over time. The theoretical results provide no presumption about the effects of the length of the holding period on the optimal portfolio. Using estimated processes for stock and bill returns, we show that calculated optimal portfolios are virtually invariant to the length of the holding period. The estimated processes for asset returns also imply very little difference between portfolios calculated ignoring changes in the investment opportunity set and those obtained when the investment opportunity set changes over time.

Deriving developing country repayment capacity from the market prices of sovereign debt

The market prices of developing countries'debts are imperfect indicators of the countries'payment capacity for three reasons: the concave shape of the debt's payoff structure, the presence of third-party guarantees, and the differences in the terms of various debt claims. Claessens and Pennacchi derive an improved indicator of payment capacityby developing a pricing model - using option valuation techniques - that takes these three factors into account. Applying the model to bonds issued recently by Mexico and Venezuela, they find that the estimated indicator of payment capacity often behaves differently from the raw bond prices themselves, confirming the importance of cleaning the raw prices for these three factors. In order of importance, the benefits of cleaning raw prices come first from correcting for the effects of different terms (such as fixed versus floating interest rates), followed by the value of third-party enhancements and then by the concavity of the payoff structure. They find some evidence that the new indicator of repayment capacity conforms better than the raw prices themselves to generally held beliefs about which variables drive a country's repayment capacity. In particular, they find that variables that are often assumed to be related to payment capacity - such as oil prices and the countries'stock market prices - are more closely (and with the right sign) associated with the new estimated measure of payment capacity than are the secondary market prices of the bonds.Economic Theory&Research,Environmental Economics&Policies,Banks&Banking Reform,Strategic Debt Management,Settlement of Investment Disputes

Bank deposit rate clustering: theory and empirical evidence

An examination of banks' optimal deposit-rate-setting behavior when some customers have limited recall, showing that when banks exploit this phenomenon, deposit rates will tend to be set at round fractions and will be relatively "sticky" at these levels.Bank deposits ; Interest ; Prices

Estimating the cost of U.S. indexed bonds

A presentation of an equilibrium bond-pricing model driven by two stochastic factors: the real interest rate and the expected rate of inflation. The models parameters are estimated using a maximum-likelihood technique based on a Kalman filter.Government securities ; Inflation (Finance) ; Interest rates ; Indexation (Economics)

A structural model of contingent bank capital

This paper develops a structural credit risk model of a bank that issues deposits, shareholders' equity, and fixed or floating coupon bonds in the form of contingent capital or subordinated debt. The return on the bank's assets follows a jump-diffusion process, and default-free interest rates are stochastic. The equilibrium pricing of the bank's deposits, contingent capital, and shareholders' equity is studied for various parameter values haracterizing the bank's risk and the contractual terms of its contingent capital. Allowing for the possibility of jumps in the bank's asset value, as might occur during a financial crisis, has distinctive implications for valuing contingent capital. Credit spreads on contingent capital are higher the lower is the value of shareholders' equity at which conversion occurs and the larger is the conversion discount from the bond's par value. The effect of requiring a decline in a financial stock price index for conversion (dual price trigger) is to make contingent capital more similar to non-convertible subordinated debt. The paper also examines the bank's incentive to increase risk when it issues different forms of contingent capital as well as subordinated debt. In general, a bank that issues contingent capital has a moral hazard incentive to raise its assets' risk of jumps, particularly when the value of equity at the conversion threshold is low. However, moral hazard when issuing contingent capital tends to be less than when issuing subordinated debt. Because it reduces effective leverage and the pressure for government bailouts, contingent capital deserves serious consideration as part of a package of reforms that stabilize the financial system and eliminate "Too-Big-to-Fail."Bank capital ; Risk ; Bank failures

Inflation expectations, real rates, and risk premia: evidence from inflation swaps

This paper develops a model of the term structures of nominal and real interest rates driven by state variables representing the short-term real interest rate, expected inflation, inflation’s central tendency, and four volatility factors that follow GARCH processes. We derive analytical solutions for nominal bond yields, yields on inflation-indexed bonds that have an indexation lag, and the term structure of expected inflation. Unlike prior studies, the model’s parameters are estimated using data on inflation swap rates, as well as nominal yields and survey forecasts of inflation. The volatility state variables fully determine bonds’ time-varying risk premia and allow for stochastic volatility and correlation between bond yields, yet they have small effects on the cross section of nominal yields. Allowing for time-varying volatility is particularly important for real interest rate and expected inflation processes, but long-horizon real and inflation risk premia are relatively stable. Comparing our model prices of inflation-indexed bonds to those of Treasury Inflation Protected Securities (TIPS) suggests that TIPS were significantly underpriced prior to 2004 and again during the 2008-2009 financial crisis.Inflation (Finance) ; Interest rates ; Asset pricing