Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints

The consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out to its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stock holders with preferences that incorporate elements of the prospect theory developed by Kahneman and Tversky (1979). In addition to consumption, stockholders consider fluctuations in their financial wealth explicitly when making decisions. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 5.5% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle reported by Mehra and Prescott (1985).

Monetary Policy in a Portfolio Balance Model with Endogenous Physical Capital

We develop a portfolio balance model with real capital accumulation. The introduction of real capital as an asset as well as a good produced and demanded by firms enriches extant portfolio balance models of exchange rate determination. We show that expansionary monetary policy causes exchange rate overshooting, not once, but twice; the secondary repercussion comes through the reaction of firms to changed asset prices and the firms' decisions to invest in real capital. The model sheds further light on the volatility of real and nominal exchange rates, and it suggests that changes in corporate sector profitability may affect exchange rates through portfolio diversification in corporate securities.

Capital Accumulation in the Presence of Informal Credit Contracts: Does the Incentive Mechanism Work Better than Credit Rationing Under Asymmetric Information?

Credit markets with asymmetric information often prefer credit rationing as a profit maximizing device. This paper asks whether the presence of informal credit markets reduces the cost of credit rationing, that is, whether it can alleviate the impact of asymmetric information based on the available information. We used a dynamic general equilibrium model with heterogenous agents to assess this. Using Indian credit market data our study shows that the presence of informal credit market can reduce the cost of credit rationing by separating high risk firms from the low risk firms in the informal market. But even after this improvement, the steady state capital accumulation is still much lower as compared to incentive based market clearing rates. Through self revelation of each firm's type, based on the incentive mechanism, banks can diversify their risk by achieving a separating equilibrium in the loan market. The incentive mechanism helps banks to increase capital accumulation in the long run by charging lower rates and lending relatively higher amount to the less risky firms. Another important finding of this study is that self-revelation leads to very significant welfare improvement, as measured by consumptiuon equivalence.

A Generic Model of Financial Repression

The paper develops a growth model in an overlapping generations framework of a financially repressed small open economy, and analyzes the effects of financial liberalization. The following observations are made: An increase (decrease) of interest rate (reserve requirements) reduces (increases) the steady-state stock of capital and the trade balance, but improves (deteriorates) the level of foreign exchange reserves. However, financial liberalization, in any form, is always welfare-improving. The paper, thus, advocates financial liberalization policies to be oriented towards reduction of reserve requirements rather than interest rate deregulation, if foreign reserve holding is not in a critical position.

The Optimal Capital Structure of Banks: Balancing Deposit Insurance, Capital Requirements and Tax-Advantaged Debt

The capital structure and regulation of financial intermediaries is an important topic for practitioners, regulators and academic researchers. In general, theory predicts that firms choose their capital structures by balancing the benefits of debt (e.g., tax and agency benefits) against its costs (e.g., bankruptcy costs). However, when traditional corporate finance models have been applied to insured financial institutions, the results have generally predicted corner solutions (all equity or all debt) to the capital structure problem. This paper studies the impact and interaction of deposit insurance, capital requirements and tax benefits on a bankÇs choice of optimal capital structure. Using a contingent claims model to value the firm and its associated claims, we find that there exists an interior optimal capital ratio in the presence of deposit insurance, taxes and a minimum fixed capital standard. Banks voluntarily choose to maintain capital in excess of the minimum required in order to balance the risks of insolvency (especially the loss of future tax benefits) against the benefits of additional debt. Because we derive a closed- form solution, our model provides useful insights on several current policy debates including revisions to the regulatory framework for GSEs, tax policy in general and the tax exemption for credit unions.

Transfer Pricing in the Decentralized Multinational Corporation

This paper considers how the multinational corporation's transfer price responds to changes in international corporate effective tax rates. It extends the decentralized decision-making analysis of transfer pricing in the context of different tax rates. It adopts and extends Bond's (1980) model of the decentralized multinational corporation that assumes centralized transfer pricing. The direction of transfer price change is as expected, while the magnitude of change is likely to be less than predicted by the Horst (1971), centralized decision-making model. The paper extends the model further by assuming negotiated transfer pricing, where the analysis is partitioned into perfect and imperfect information cases. The negotiated transfer pricing result reverts to the Horst (1971), or centralized decision-making, result, under perfect information. Under imperfect information, the centralized decision-making result obtains when top management successfully informs division general managers or it successfully implements a non-monetary reward scheme to encourage division general managers to cooperate. Under simplifying assumptions, centralized decision-making dominates decentralized decision-making, while negotiated transfer pricing weakly dominates centralized transfer pricing.

Bankruptcy Costs, Liability Dollarization, and Vulnerability to Sudden Stops

Emerging market countries that have improved institutions and attained intermediate levels of institutional quality have experienced severe financial crises following capital flow reversals. However, there is also evidence that countries with strong institutions and deep capital markets are less affected by external shocks. We reconcile these two observations using a calibrated DSGE model that extends the financial accelerator framework developed in Bernanke, Gertler, and Gilchrist (1999). The model captures financial market institutional quality with creditors. ability to recover assets from bankrupt firms. Bankruptcy costs affect vulnerability to sudden stops directly but also indirectly by affecting the degree of liability dollarization. Simulations reveal an inverted U-shaped relationship between bankruptcy recovery rates and the output loss following sudden stops. We provide empirical evidence that this non-linear relationship exists.

Monetary Policy, Exchange Rate Overshooting, and Endogenous Physical Capital

We develop an open economy macroeconomic model with real capital accumulation and microeconomic foundations. We show that expansionary monetary policy causes exchange rate overshooting, not once, but potentially twice; the secondary repercussion comes through the reaction of firms to changed asset prices and the firms' decisions to invest in real capital. The model sheds further light on the volatility of real and nominal exchange rates, and it suggests that changes in corporate sector profitability may affect exchange rates through international portfolio diversification in corporate securities.

Human Capital and Interethnic Marriage Decisions

Despite a longstanding belief that education importantly affects the process of immigrant assimilation, little is known about the relative importance of different mechanisms linking these two processes. This paper explores this issue through an examination of the effects of human capital on one dimension of assimilation, immigrant intermarriage. I argue that there are three primary mechanisms through which human capital affects the probability of intermarriage. First, human capital may make immigrants better able to adapt to the native culture thereby making it easier to share a household with a native. Second, it may raise the likelihood that immigrants leave ethnic enclaves, thereby decreasing the opportunity to meet potential spouses of the same ethnicity. Finally, assortative matching on education in the marriage market suggests that immigrants may be willing to trade similarities in ethnicity for similarities in education when evaluating potential spouses. Using a simple spouse-search model, I first derive an identification strategy for differentiating the cultural adaptability effect from the assortative matching effect, and then I obtain empirical estimates of their relative importance while controlling for the enclave effect. Using U.S. Census data, I find that assortative matching on education is the most important avenue through which human capital affects the probability of intermarriage. Further support for the model is provided by deriving and testing some of its additional implications.

Expectations, and Credibility in a Model of Monetary Policy

Recent monetary history has been characterized by monetary authorities which have been, alternatively hard and soft on inflation. In a vintage capital framework, investment decisions are not easily reversed. Therefore, expectations of policy as well as current policy are important to the investment decision. Here, a vintage capital model is used to assess the value of central bank credibility for a policy change. Policy in this model is assumed to be private information of the central banker. Agents learn about that policy which to study the ensuing transitional dynamics following a change in monetary policy regime.