No Good Deals - No Bad Models

Faced with the problem of pricing complex contingent claims, an investor seeks to make his valuations robust to model uncertainty. We construct a notion of a model- uncertainty-induced utility function and show that model uncertainty increases the investor's eff ective risk aversion. Using the model-uncertainty-induced utility function, we extend the \No Good Deals" methodology of Cochrane and Sa a-Requejo [2000] to compute lower and upper good deal bounds in the presence of model uncertainty. We illustrate the methodology using some numerical examples.

Pecuniary Externality through Credit Constraints: Two Examples without Uncertainty

This paper is a contribution to the growing literature on constrained inefficiencies in economies with financial frictions. The purpose is to present two simple examples, inspired by the stochastic models in Gersbach-Rochet (2012) and Lorenzoni (2008), of deterministic environments in which such inefficiencies arise through credit constraints. Common to both examples is a pecuniary externality, which operates through an asset price. In the second example, a simple transfer between two groups of agents can bring about a Pareto improvement. In a first best economy, there are no pecuniary externalities because marginal productivities are equalised. But when agents face credit constraints, there is a wedge between their marginal productivities and those of the non-credit-constrained agents. The wedge is the source of the pecuniary externality: economies with these kinds of imperfections in credit markets are not second-best efficient. This is akin to the constrained inefficiency of an economy with incomplete markets, as in Geanakoplos and Polemarchakis (1986).

Self-Fulfilling Price Cycles

This paper presents a model of a self-fulfilling price cycle in an asset market. Price oscillates deterministically even though the underlying environment is stationary. The mechanism that we uncover is driven by endogenous variation in the investment horizons of the different market participants, informed and uninformed. On even days, the price is high; on odd days it is low. On even days, informed traders are willing to jettison their good assets, knowing that they can buy them back the next day, when the price is low. The anticipated drop in price more than offsets any potential loss in dividend. Because of these asset sales, the informed build up their cash holdings. Understanding that the market is flooded with good assets, the uninformed traders are willing to pay a high price. But their investment horizon is longer than that of the informed traders: their intention is to hold the assets they purchase, not to resell. On odd days, the price is low because the uninformed recognise that the informed are using their cash holdings to cherry-pick good assets from the market. Now the uninformed, like the informed, are investing short-term. Rather than buy-and-hold as they do with assets purchased on even days, on odd days the uninformed are buying to sell. Notice that, at the root of the model, there lies a credit constraint. Although the informed are flush with cash on odd days, they are not deep pockets. On each cherry that they pick out of the market, they earn a high return: buying cheap, selling dear. However they don't have enough cash to strip the market of cherries and thereby bid the price up.

Contagious Illiquidity I: Contagion through Time

This paper is an investigation into the dynamics of asset markets with adverse selection a la Akerlof (1970). The particular question asked is: can market failure at some later date precipitate market failure at an earlier date? The answer is yes: there can be "contagious illiquidity" from the future back to the present. The mechanism works as follows. If the market is expected to break down in the future, then agents holding assets they know to be lemons (assets with low returns) will be forced to hold them for longer - they cannot quickly resell them. As a result, the effective difference in payoff between a lemon and a good asset is greater. But it is known from the static Akerlof model that the greater the payoff differential between lemons and non-lemons, the more likely is the market to break down. Hence market failure in the future is more likely to lead to market failure today. Conversely, if the market is not anticipated to break down in the future, assets can be readily sold and hence an agent discovering that his or her asset is a lemon can quickly jettison it. In effect, there is little difference in payoff between a lemon and a good asset. The logic of the static Akerlof model then runs the other way: the small payoff differential is unlikely to lead to market breakdown today. The conclusion of the paper is that the nature of today's market - liquid or illiquid - hinges critically on the nature of tomorrow's market, which in turn depends on the next day's, and so on. The tail wags the dog.

The Inflation Risk Premium on Government Debt in an Overlapping Generations Model

This paper presents a general equilibrium model in which nominal government debt pays an inflation risk premium. The model predicts that the inflation risk premium will be higher in economies which are exposed to unanticipated inflation through nominal asset holdings. In particular, the inflation risk premium is higher when government debt is primarily nominal, steady-state inflation is low, and when cash and nominal debt account for a large fraction of consumers' retirement portfolios. These channels do not appear to have been highlighted in previous models or tested empirically. Numerical results suggest that the inflation risk premium is comparable in magnitude to standard representative agent models. These findings have implications for management of government debt, since the inflation risk premium makes it more costly for governments to borrow using nominal rather than indexed debt. Simulations of an extended model with Epstein-Zin preferences suggest that increasing the share of indexed debt would enable governments to permanently lower taxes by an amount that is quantitatively non-trivial.

A Simple Characterization of Dynamic Completeness in Continuous Time

This paper investigates dynamic completeness of financial markets in which the underlying risk process is a multi-dimensional Brownian motion and the risky securities dividends geometric Brownian motions. A sufficient condition, that the instantaneous dispersion matrix of the relative dividends is non-degenerate, was established recently in the literature for single-commodity, pure-exchange economies with many heterogenous agents, under the assumption that the intermediate flows of all dividends, utilities, and endowments are analytic functions. For the current setting, a different mathematical argument in which analyticity is not needed shows that a slightly weaker condition suffices for general pricing kernels. That is, dynamic completeness obtains irrespectively of preferences, endowments, and other structural elements (such as whether or not the budget constraints include only pure exchange, whether or not the time horizon is finite with lump-sum dividends available on the terminal date, etc.)

Price Transmission and Effects of Exchange Rates on Domestic Commodity Prices via Offshore and Currency Hedging

The framework presents how trading in the foreign commodity futures market and the forward exchange market can affect the optimal spot positions of domestic commodity producers and traders. It generalizes the models of Kawai and Zilcha (1986) and Kofman and Viaene (1991) to allow both intermediate and final commodities to be traded in the international and futures markets, and the exporters/importers to face production shock, domestic factor costs and a random price. Applying mean-variance expected utility, we find that a rise in the expected exchange rate can raise both supply and demand for commodities and reduce domestic prices if the exchange rate elasticity of supply is greater than that of demand. Whether higher volatilities of exchange rate and foreign futures price can reduce the optimal spot position of domestic traders depends on the correlation between the exchange rate and the foreign futures price. Even though the forward exchange market is unbiased, and there is no correlation between commodity prices and exchange rates, the exchange rate can still affect domestic trading and prices through offshore hedging and international trade if the traders are interested in their profit in domestic currency. It illustrates how the world prices and foreign futures prices of commodities and their volatility can be transmitted to the domestic market as well as the dynamic relationship between intermediate and final goods prices. The equilibrium prices depends on trader behaviour i.e. who trades or does not trade in the foreign commodity futures and domestic forward currency markets. The empirical result applying a two-stage-least-squares approach to Thai rice and rubber prices supports the theoretical result.

Money Cycles

Operating overheads are widespread and lead to concentrated bursts of activity. To transfer resources between active and idle spells, agents demand financial assets. Futures contracts and lotteries are unsuitable, as they have substantial overheads of their own.We show that money – under efficient monetary policy – is a liquid asset that leads to efficient allocations. Under all other policies, agents follow inefficient “money cycle” patterns of saving, activity, and inactivity. Agents spend their money too quickly – a “hot potato effect of inflation”. We show that inflation can stimulate inefficiently high aggregate output.

Primary Commodity Prices: Co-movements, Common Factors and Fundamentals

The behavior of commodities is critical for developing and developed countries alike. This paper contributes to the empirical evidence on the co-movement and determinants of commodity prices. Using nonstationary panel methods, we document a statistically significant degree of co-movement due to a common factor. Within a Factor Augmented VAR approach, real interest rate and uncertainty, as postulated by a simple asset pricing model, are both found to be negatively related to this common factor. This evidence is robust to the inclusion of demand and supply shocks, which both positively impact on the co-movement of commodity prices.

Multiple Objectives in Monetary Policy: A de Facto Analysis for ‘Advanced’ Countries

A statistical methodology is developed by which realised outcomes can be used to identify, for calendar years between 1974 and 2012, when policy makers in ‘advanced’ economies have successfully pursued single objectives of different kinds, or multiple objectives. A simple criterion is then used to distinguish between multiple objectives pure and simple and multiple objectives subject to a price stability constraint. The overall and individual country results which this methodology produces seem broadly plausible. Unconditional and conditional analyses of the inflation and growth associated with different types of objectives reveal that multiple objectives subject to a price stability constraint are associated with roughly as good economic performance as the single objective of inflation. A proposal is then made as to how the remit of an inflation-targeting central bank could be adjusted to allow it to pursue other objectives in extremis without losing the credibility effects associated with inflation targeting.