Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities (Draft 1)

We extend a reduced form model for pricing pass-through mortgage backed securities (MBS) and provide a novel hedging tool for investors in this market. To calculate the price of an MBS, traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS). The latter allows investors in the mortgage market to account for both prepayment risk and changes of the yield curve.

A Model of Near-Rational Exuberance

We study how the use of judgement or “add-factors” in forecasting may disturb the set of equilibrium outcomes when agents learn using recursive methods. We isolate conditions under which new phenomena, which we call exuberance equilibria, can exist in a standard self-referential environment. Local indeterminacy is not a requirement for existence. We construct a simple asset pricing example and find that exuberance equilibria, when they exist, can be extremely volatile relative to fundamental equilibria.

Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities (Draft 2)

We extend a reduced form model for pricing pass-through mortgage backed securities (MBS) and provide a novel hedging tool for investors in this market. To calculate the price of an MBS, traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS), which allows investors in the mortgage market to account for both prepayment risk and changes of the yield curve.

Global Warming And Extreme Events: Rethinking The Timing And Intensity Of Environmental Policy

The possibility of low-probability extreme events has reignited the debate over the optimal intensity and timing of climate policy. In this paper we therefore contribute to the literature by assessing the implications of low-probability extreme events on environmental policy in a continuous-time real options model with “tail risk”. In a nutshell, our results indicate the importance of tail risk and call for foresighted pre-emptive climate policies.

Revealed cardinal preference

I prove that as long as we allow the marginal utility for money (lambda) to vary between purchases (similarly to the budget) then the quasi-linear and the ordinal budget-constrained models rationalize the same data. However, we know that lambda is approximately constant. I provide a simple constructive proof for the necessary and sufficient condition for the constant lambda rationalization, which I argue should replace the Generalized Axiom of Revealed Preference in empirical studies of consumer behavior. 'Go Cardinals!' It is the minimal requirement of any scientifi c theory that it is consistent with the data it is trying to explain. In the case of (Hicksian) consumer theory it was revealed preference -introduced by Samuelson (1938,1948) - that provided an empirical test to satisfy this need. At that time most of economic reasoning was done in terms of a competitive general equilibrium, a concept abstract enough so that it can be built on the ordinal preferences over baskets of goods - even if the extremely specialized ones of Arrow and Debreu. However, starting in the sixties, economics has moved beyond the 'invisible hand' explanation of how -even competitive- markets operate. A seemingly unavoidable step of this 'revolution' was that ever since, most economic research has been carried out in a partial equilibrium context. Now, the partial equilibrium approach does not mean that the rest of the markets are ignored, rather that they are held constant. In other words, there is a special commodity -call it money - that reflects the trade-offs of moving purchasing power across markets. As a result, the basic building block of consumer behavior in partial equilibrium is no longer the consumer's preferences over goods, rather her valuation of them, in terms of money. This new paradigm necessitates a new theory of revealed preference.

Finite Horizon Learning

Incorporating adaptive learning into macroeconomics requires assumptions about how agents incorporate their forecasts into their decision-making. We develop a theory of bounded rationality that we call finite-horizon learning. This approach generalizes the two existing benchmarks in the literature: Eulerequation learning, which assumes that consumption decisions are made to satisfy the one-step-ahead perceived Euler equation; and infinite-horizon learning, in which consumption today is determined optimally from an infinite-horizon optimization problem with given beliefs. In our approach, agents hold a finite forecasting/planning horizon. We find for the Ramsey model that the unique rational expectations equilibrium is E-stable at all horizons. However, transitional dynamics can differ significantly depending upon the horizon.

Macroeconomics: Science or Faith Based Discipline?

Whether or not macroeconomics is a science depends on the scientific nature of macroeconomic theories and how the discipline responds when the empirical evidence fails to match the underlying assumptions and predictions of the theories. By way of an example, four conditions for macroeconomics to be a science are developed and used to examine the 'modern' theories of the Phillips curve. It is found that while the discipline in general maintains one condition it routinely violates the other three. This suggests the macroeconomics discipline has some way to go before it can call itself a 'pure science.'

Meeting technologies and optimal trading mechanisms in competitive search markets

In a market in which sellers compete by posting mechanisms, we study how the properties of the meeting technology affect the mechanism that sellers select. In general, sellers have incentive to use mechanisms that are socially efficient. In our environment, sellers achieve this by posting an auction with a reserve price equal to their own valuation, along with a transfer that is paid by (or to) all buyers with whom the seller meets. However, we define a novel condition on meeting technologies, which we call “invariance,” and show that the transfer is equal to zero if and only if the meeting technology satisfies this condition.

Global Warming and Fat Tailed-uncertainty: Rethinking the Timing and Intensity of Climate Policy

The possibility of low-probability extreme natural events has reignited the debate over the optimal intensity and timing of climate policy. In this paper, we contribute to the literature by assessing the implications of low-probability extreme events on environmental policy in a continuous-time real options model with “tail risk”. In a nutshell, our results indicate the importance of tail risk and call for foresighted pre-emptive climate policies.