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)

Contagion in Financial Markets

This paper presents a model on contagion in nancial markets. We use a bank run framework as a mechanism to initiate a crisis and argues that liquidity crunch and imperfect information are the key culprits for a crisis to be contagious. The model proposes that a crisis is more likely to be contagious when (1) banks have similar cost-effciency structures (clustering) and (2) a large fraction of the investment is in the illiquid sector (illiquidity). The latter is an endogenous decision made by the banks. It increases with (1) the prospect of the risky asset (risk-return trade-off) and (2) the fraction of patient consumers (liquidity demand).contagion, liquidity crunch, market crash, bank run, capital flight

The Conditional Distribution of Excess Returns: An Empirical Analysis

In this paper we describe the cumulative distribution function of excess returns conditional on a broad set of predictors that summarize the state of the economy. We do so by estimating a sequence of conditional logit models over a grid of values of the response variable. Our method uncovers higher-order multidimensional structure that cannot be found by modeling only the first two moments of the distribution. We compare two approaches to modeling: one based on a conventional linear logit model, the other an additive logit. The second approach avoids the “curse of dimensionality” problem of fully nonparametric methods while retaining both interpretability and the ability to let the data determine the shape of the relationship between the response variable and the predictors. We find that additive logit fits better and reveals aspects of the data that remain undetected by the linear logit. The additive model retains its superiority even in out-of-sample prediction and portfolio selection performance, suggesting that this model captures genuine features of the data which seem to be important to guide investors’ optimal portfolio choices

Money, Transactions, and Portfolio Choice

Real money balances are held separately for consumption and portfolio reasons. When real balances are a state variable in the investor’s optimization problem, there is a specific inflation-hedging portfolio. An investor hedges against inflation when the effect of real money holdings on the marginal utility of wealth is negative. We show that an increase in real balances due to inflation has two opposite effects on the marginal utility of wealth. On the one hand, the decrease in the real balances reduces consumption, which in turn raises the marginal utility and decreases the marginal cost of consuming: this explains why an investor would normally hedge inflation. One the other hand, the decrease in real balances tends to increase the marginal cost of consuming. When this second effect dominates, we have the somewhat surprising result that the investor reverse-hedges inflation

The Simple Analytics of Assets' Values and Infrequent Policy Changes

This paper studies the effects on financial markets of an anticipated fiscal stabilization policy in a stochastic environment. Stabilization is defined as a discrete change in the budget process which is implemented when government consumption reaches some threshold level, known by economic agents. Our analysis integrates the study of financial markets within the framework adopted by Bertola and Drazen (1993) to explain the effects of private consumption of an anticipated fiscal retrenchment, such as the fiscal reform implemented in Denmark in 1983. The actual behavior of Danish financial markets points in the direction of two interesting features of the policy change. First, in a model intertemporal consumption smoothing, one can replicate the observed boom in the stock market only with expectations of an increase in net income to stock-holders. The term-structure evidence on the other hand, is consistent with less than full credibility of the retrenchment, that is with investors attaching some probability to a further expansion of the government sector

Affine Models of Currency Pricing

Perhaps the most puzzling feature of currency prices is the tendency for high interest rate currencies to appreciate when the expectations hypothesis suggests the reverse. Some have attributed this forward premium anomaly to a time-varying risk premium but theory has been largely unsuccessful in producing a risk premium with the requisite properties. We characterize the risk premium in a general arbitrage-free setting and describe the features a theory must have to account for the anomaly. In affine models the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that we abandon the common requirement that interest rates be strictly positive

Interest Rate Targeting and the Dynamics of Short-Term Rates

We explore the link between the overnight fed funds rate, which is actively targeted by the Federal Reserve, and longer-maturity term fed funds rates. We develop a term-structure model which explicitly accounts for interest rate targeting and for the predictability of future target changes. The model is able to replicate some qualitative features of the dynamic behavior of deviations of short-term rates from the target

The Simple Analytics of Assets' Values and Infrequent Policy Changes

This paper studies the effects on financial markets of an anticipated fiscal stabilization policy in a stochastic environment. Stabilization is defined as a discrete change in the budget process which is implemented when government consumption reaches some threshold level, known by economic agents. Our analysis integrates the study of financial markets within the framework adopted by Bertola and Drazen (1993) to explain the effects of private consumption of an anticipated fiscal retrenchment, such as the fiscal reform implemented in Denmark in 1983. The actual behavior of Danish financial markets points in the direction of two interesting features of the policy change. First, in a model intertemporal consumption smoothing, one can replicate the observed boom in the stock market only with expectations of an increase in net income to stock-holders. The term-structure evidence on the other hand, is consistent with less than full credibility of the retrenchment, that is with investors attaching some probability to a further expansion of the government sector

Asset Price Dynamics and Infrequent Trades

We model an economy where stocks and bonds (consols) are traded by two types of agents: speculators, expected utility maximizers always present in the market, and infrequent traders, whose trading motives are not explicitly modeled. A solution technique for equilibrium prices is developed when trades are triggered by stock prices reaching some threshold level, corresponding to a specific value of the dividend flow. Across trade scenarios we find expectations of stock sales to depress stock prices relative to the no-trade case, while expectations of stock purchases tend to inflate them .both effects bring about heteroskedasticity and predictability of stock returns. Our analysis yields insights as to the equilibrium effects of a variety of trading strategies, which mechanically generate market orders in response to changes in stock prices