Imperfect Knowledge Economics: Exchange Rates and Risk

Posing a major challenge to economic orthodoxy, Imperfect Knowledge Economics asserts that exact models of purposeful human behavior are beyond the reach of economic analysis. Roman Frydman and Michael Goldberg argue that the longstanding empirical failures of conventional economic models stem from their futile efforts to make exact predictions about the consequences of rational, self-interested behavior. Such predictions, based on mechanistic models of human behavior, disregard the importance of individual creativity and unforeseeable sociopolitical change. Scientific though these explanations may appear, they usually fail to predict how markets behave. And, the authors contend, recent behavioral models of the market are no less mechanistic than their conventional counterparts: they aim to generate exact predictions of "irrational" human behavior. Frydman and Goldberg offer a long-overdue response to the shortcomings of conventional economic models. Drawing attention to the inherent limits of economists' knowledge, they introduce a new approach to economic analysis: Imperfect Knowledge Economics (IKE). IKE rejects exact quantitative predictions of individual decisions and market outcomes in favor of mathematical models that generate only qualitative predictions of economic change. Using the foreign exchange market as a testing ground for IKE, this book sheds new light on exchange-rate and risk-premium movements, which have confounded conventional models for decades. Offering a fresh way to think about markets and representing a potential turning point in economics, Imperfect Knowledge Economics will be essential reading for economists, policymakers, and professional investors.knowledge, economic models, predictions, rational self-interest, markets, decisions, exchange rates, risk premiums

Imperfect Knowledge and Asset Price Dynamics: Modeling the Forecasting of Rational Agents, Dynamic Prospect Theory and Uncertainty Premia on Foreign Exchange.

Models using the Rational Expectations Hypothesis (REH) are widely recognized to be inconsistent with the observed behavior of premia in financial markets, as well as other features of asset price dynamics. Moreover, many reasons have been advanced as to why the REH cannot generally represent, even approximately, the expectations behavior of individually rational agents. In this paper, we develop a new model of the equilibrium premium in the foreign exchange market that replaces the REH with the Imperfect Knowledge Forecasting (IKF) framework. Because we maintain that agents must cope with imperfect knowledge and that they are not grossly irrational, our IKF approach imposes only qualitative conditions on the formation of individual forecasting models and their updating. We also develop a dynamic extension of the original formulation of Kahneman and Tversky’s prospect theory. We find that under IKF and dynamic prospect theory, the equilibrium premium on foreign exchange is positively related to the gap between the aggregate forecast of the exchange rate and its historical benchmark level. We test this implication, using survey data on the German mark-U.S. dollar exchange rate, and find that the behavior of the ex ante premium on foreign exchange is consistent with our model of the premium.exchange rates; risk premium; imperfect knowledge; individual rationality; expectations; prospect theory

Imperfect Knowledge, Temporal Instability and an Uncertainty Premium: Towards a Resolution of the Excess-Returns Puzzle in the Foreign Exchange Market.

This paper offers a refinement and explores a resolution of the excess-returns puzzle in the foreign exchange market. We find that the predictions of the forward premium are not negatively biased throughout the three decades of floating, as commonly believed, but rather are sometimes positively biased, negatively biased, unbiased or possess no predictive content depending on the subperiod examined. To explain this modified puzzle, the paper makes use of a recently developed model of the risk premium, which we have called an aggregate uncertainty premium. Our model employs an alternative approach to modeling exchange rate expectations, dubbed Imperfect Knowledge Expectations (IKE), which recognizes that rational agents do form expectations based on imperfect knowledge. Our model also makes use of a dynamic extension of the assumption of myopic loss aversion. We find that our IKE-based approach can account for the pattern of positive and negative biases estimated over three decades of floating rates.exchange rates; forward-premium anomaly; instability; imperfect knowledge expectations; risk premium

Cost Inefficiency, Size of Firms and Takeovers

This study, using the Cox proportional hazards model, finds that the risk of takeover rises with cost inefficiency. It also finds that a firm faces a significantly higher risk of takeover if its cost performance lags behind its industry benchmark. Moreover, these findings appear to be remarkably stable over the nearly two decades spanned by the sample. The effect of the variables used to measure the risk-size relationship, however, indicates temporal changes. Lastly, the study presents evidence from fixed-effects models of ex post cost efficiency improvements that support the hypothesis that takeover targets are selected based on the potential for improvement.Statistics Working Papers Serie

Cost Inefficiency, Size of Firms, and Takeovers

This study, using the Cox proportional hazards model, finds that the risk of takeover rises with cost inefficiency. It also finds that a firm faces a significantly higher risk of takeover if its cost performance lags behind its industry benchmark. These findings, moreover, appear to be remarkably stable over the nearly two decades spanned by the sample. The effect of the variables measuring the risk-size relationship, however, indicate temporal changes. Lastly, the study presents evidence from fixed-effects models of ex post cost efficiency improvements that support the hypothesis that takeover targets are selected based on the potential for improvement

Institutional Reform in Eastern Europe: Evolution or Design?

Most recent studies of privatization in Eastern Europe focus on its impact on individual enterprises. In our previous work, we examined this issue from the viewpoint of the future corporate governance structure in Eastern Europe. The aggregate effects of privatization have been largely neglected, perhaps on the assumption that they have no particular bearing on how privatization is to be effected at the enterprise level. It is very important, however, to link the discussion of the various approaches to large-scale privatization with a consideration of other obstacles in the transition to a market economy. These obstacles, which include the weakness of existing capital stock, the absence of a banking system and the absence of capital markets, can be overcome through the use of a combination of design and reliance on market mechanisms. This combination can provide a successful transition to a market economy

Institutional Reform in Eastern Europe: Evolution or Design?

Most recent studies of privatization in Eastern Europe focus on its impact on individual enterprises. In our previous work, we examined this issue from the viewpoint of the future corporate governance structure in Eastern Europe. The aggregate effects of privatization have been largely neglected, perhaps on the assumption that they have no particular bearing on how privatization is to be effected at the enterprise level. It is very important, however, to link the discussion of the various approaches to large-scale privatization with a consideration of other obstacles in the transition to a market economy. These obstacles, which include the weakness of existing capital stock, the absence of a banking system and the absence of capital markets, can be overcome through the use of a combination of design and reliance on market mechanisms. This combination can provide a successful transition to a market economy

Testing Hypotheses in an I(2) Model with Applications to the Persistent Long Swings in the Dmk/$ Rate

This paper discusses a number of likelihood ratio tests on long-run relations and common trends in the I(2) model and provide new results on the test of overidentifying restrictions on β’xt and the asymptotic variance for the stochastic trends parameters, α⊥1: How to specify deterministic components in the I(2) model is discussed at some length. Model specification and tests are illustrated with an empirical analysis of long and persistent swings in the foreign exchange market between Germany and USA. The data analyzed consist of nominal exchange rates, relative prices, US inflation rate, two long-term interest rates and two short-term interest rates over the 1975-1999 period. One important aim of the paper is to demonstrate that by structuring the data with the help of the I(2) model one can achieve a better understanding of the empirical regularities underlying the persistent swings in nominal exchange rates, typical in periods of floating exchange ratesPPP puzzle; forward premium puzzle; cointegrated VAR; likelihood inference

The Limits of Discipline

This paper, based on a large sample of mid-sized manufacturing firms in the Czech Republic, Hungary, and Poland, examines differences in the behavior of state and private companies in short-term credit markets in transition economies. The study offers three main conclusions. First, we find that state enterprises represent a higher credit risk both because of their inferior economic performance and because of their lesser willingness or propensity to meet their payment obligations. Second, the brunt of the state firms' lower creditworthiness is borne by their state creditors, as state enterprises deflect the higher risk away from private creditors. Third, this transfer of risks from private to state creditors is possible because state creditors impose significantly "softer" financial discipline on state firms. Inasmuch as such softness may reflect unwillingness to accept a likely demise of a large number of state firms that are in principle capable of successful restructuring through ownership changes, we conclude that the imposition of financial discipline is not sufficient to remedy ownership and governance-related deficiencies of corporate performance.Ownership, Financial Discipline, Performance, Transition