Defining bad news: Changes in return distribution that decrease risky asset demand

We provide a random variable characterization of the necessary and sufficient conditions for a shift of the distribution of rate of return on the risky asset in the two asset portfolio problem to reduce demand for all risk--averse expected utility maximizing investors. We provide random variable characterizations of the shifts that reduce both demand and expected utility for all risk--averse investors and a random variable characterization of shifts in the payoff of the market portfolio that reduce the equilibrium price of the market portfolio and make all risk--investors worse off.

The Personal Tax Advantage of Equity

We compute the value of a firm that pays its cash flows each period through share repurchases in a dynamic environment where personal taxes are paid on realized capital gains and dividends. These results provide a measure of the personal tax advantages of equity financing relative to debt financing, which are often cited as increasing the cost of debt. The initial price of the firm depends on the present value of the taxes paid, which, in turn, depends on the initial price. We solve this valuation problem in closed form in a deterministic setting and numerically in a stochastic setting. We find significant valuation effects from the tax protection afforded by the equity basis. The tax savings are on the order of 40-50\% of the taxes paid by the shareholders of firm that distributes cash through dividends, and the cost of capital is reduced by approximately .8 to 1.2 percentage points through the use of repurchases relative to dividends.

Taylor Rules, McCallum Rules and the Term Structure of Interest Rates

term structure, monetary policy, Taylor rule

What Broker Charges Reveal about Mortgage Credit Risk previously entitled "The Role of Mortgage Brokers in the Subprime Crisis"

Prior to the subprime crisis, mortgage brokers charged higher percentage fees for loans that turned out to be riskier ex post, even when conditioning on other risk characteristics. High conditional fees reveal borrower attributes that are associated with high borrower risk, such as suboptimal shopping behavior, high valuation for the loan or high borrower-specific broker costs. Borrowers who pay high conditional fees are inherently more risky, not just because they pay high fees. We find a stronger association between conditional fees and delinquency risk when lenders have fewer incentives to screen borrowers, for purchase rather than refinance loans, and for loans originated by brokers who have less frequent interactions with the lender. Our findings shed light on the proposed QRM exemption criteria for risk retention requirements for residential mortgage securitizations.

Dealer Intermediation and Price Behavior in the Aftermarket for New Bond Issues

We study trading and prices in newly issued municipal bonds. Municipals, which trade in decentralized, broker-dealer markets, are underpriced when issued, but unlike equities the average price rises slowly over a period of several days. We document high levels of price dispersion in newly issued bonds, and show that the average drift upward in price is because of changes in the mix of trades over time. While large trades occur at prices close to the reoffering yield, and close to each other, small trades occur at a wide range of prices almost simultaneously. Some small investors appear to be informed about the status of the issue, and trade on attractive terms. Others appear uninformed, and broker/dealers are able to discriminate between them.

Financial leverage and the leverage effect: A market and firm analysis

We quantify the effect of financial leverage on stock return volatility in a dynamic general equilibrium economy with debt and equity claims. The effect of financial leverage is studied both at a market and a firm level where the firm is exposed to both idiosyncratic and market risk. In a benchmark economy with both a constant interest rate and constant price of risk, financial leverage generates little variation in stock return volatility at the market level but significant variation at the individual firm level. In an economy that generates time-variation in interest rates and the price of risk, there is significant variation in stock return volatility at the market and firm level. In such an economy, financial leverage has little effect on the dynamics of stock return volatility at the market level. Financial leverage contributes more to the dynamics of stock return volatility for a small firm.

Taylor Rules, McCallum Rules and the Term Structure of Interest Rates

Recent empirical research shows that a reasonable characterization of federal-funds-rate targeting behavior is that the change in the target rate depends on the maturity structure of interest rates and exhibits little dependence on lagged target rates. See, for example, Cochrane and Piazzesi (2002). The result echoes the policy rule used by McCallum (1994) to rationalize the empirical failure of the `expectations hypothesis' applied to the term- structure of interest rates. That is, rather than forward rates acting as unbiased predictors of future short rates, the historical evidence suggests that the correlation between forward rates and future short rates is surprisingly low. McCallum showed that a desire by the monetary authority to adjust short rates in response to exogenous shocks to the term premiums imbedded in long rates (i.e. "yield-curve smoothing"), along with a desire for smoothing interest rates across time, can generate term structures that account for the puzzling regression results of Fama and Bliss (1987). McCallum also clearly pointed out that this reduced-form approach to the policy rule, although naturally forward looking, needed to be studied further in the context of other response functions such as the now standard Taylor (1993) rule. We explore both the robustness of McCallum's result to endogenous models of the term premium and also its connections to the Taylor Rule. We model the term premium endogenously using two different models in the class of affine term structure models studied in Duffie and Kan (1996): a stochastic volatility model and a stochastic price-of- risk model. We then solve for equilibrium term structures in environments in which interest rate targeting follows a rule such as the one suggested by McCallum (i.e., the "McCallum Rule"). We demonstrate that McCallum's original result generalizes in a natural way to this broader class of models. To understand the connection to the Taylor Rule, we then consider two structural macroeconomic models which have reduced forms that correspond to the two affine models and provide a macroeconomic interpretation of abstract state variables (as in Ang and Piazzesi (2003)). Moreover, such structural models allow us to interpret the parameters of the term-structure model in terms of the parameters governing preferences, technologies, and policy rules. We show how a monetary policy rule will manifest itself in the equilibrium asset-pricing kernel and, hence, the equilibrium term structure. We then show how this policy can be implemented with an interest-rate targeting rule. This provides us with a set of restrictions under which the Taylor and McCallum Rules are equivalent in the sense if implementing the same monetary policy. We conclude with some numerical examples that explore the quantitative link between these two models of monetary policy.

Financial Intermediation and the Costs of Trading in an Opaque Market

Municipal bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather. Whether dealers in such a market operate competitively is an empirical issue, but a difficult one to study. Data in such markets is generally not centrally recorded. We analyze a comprehensive database of all trades between broker-dealers in municipal bonds and their customers. The data is only released to the public with a substancial lag, and thus the market was relativela opaque to the traders themselves during our sample period. We find that dealers earn lower average markups on larger trades, even though larger trades lead the dealers to bear more risk of losses. We formulate and estimate a simple structural bargaining model that allows us to estimate mesures of dealer bargaining power and it relate it to the characteristics of the trades. The results suggest dealers exercise substancial market power. Our mesures of market power decrease in trade size and increase in variables that indicate the complexity of the trade for the dealer.Municipal Bonds, Fixed Income Dealer, Transaction Costs, Liquidity, Transparency, Market Power