In Search of a theory of debt management

A growing literature integrates theories of debt management into models of optimal fiscal policy. One promising theory argues that the composition of government debt should be chosen so that fluctuations in the market value of debt offset changes in expected future deficits. This complete market approach to debt management is valid even when the government only issues non-contingent bonds. A number of authors conclude from this approach that governments should issue long term debt and invest in short term assets. We argue that the conclusions of this approach are too fragile to serve as a basis for policy recommendations. This is because bonds at different maturities have highly correlated returns, causing the determination of the optimal portfolio to be ill-conditioned. To make this point concrete we examine the implications of this approach to debt management in various models, both analytically and using numerical methods calibrated to the US economy. We find the complete market approach recommends asset positions which are huge multiples of GDP. Introducing persistent shocks or capital accumulation only worsens this problem. Increasing the volatility of interest rates through habits partly reduces the size of these simulations we find no presumption that governments should issue long term debt ? policy recommendations can be easily reversed through small perturbations in the specification of shocks or small variations in the maturity of bonds issued. We further extend the literature by removing the assumption that governments every period costlessly repurchase all outstanding debt. This exacerbates the size of the required positions, worsens their volatility and in some cases produces instability in debt holdings. We conclude that it is very difficult to insulate fiscal policy from shocks by using the complete markets approach to debt management. Given the limited variability of the yield curve using maturities is a poor way to substitute for state contingent debt. The result is the positions recommended by this approach conflict with a number of features that we believe are important in making bond markets incomplete e.g allowing for transaction costs, liquidity effects, etc.. Until these features are all fully incorporated we remain in search of a theory of debt management capable of providing robust policy insights.

Three essays on the psychology of investment and financial markets

Préface My thesis consists of three essays where I consider equilibrium asset prices and investment strategies when the market is likely to experience crashes and possibly sharp windfalls. Although each part is written as an independent and self contained article, the papers share a common behavioral approach in representing investors preferences regarding to extremal returns. Investors utility is defined over their relative performance rather than over their final wealth position, a method first proposed by Markowitz (1952b) and by Kahneman and Tversky (1979), that I extend to incorporate preferences over extremal outcomes. With the failure of the traditional expected utility models in reproducing the observed stylized features of financial markets, the Prospect theory of Kahneman and Tversky (1979) offered the first significant alternative to the expected utility paradigm by considering that people focus on gains and losses rather than on final positions. Under this setting, Barberis, Huang, and Santos (2000) and McQueen and Vorkink (2004) were able to build a representative agent optimization model which solution reproduced some of the observed risk premium and excess volatility. The research in behavioral finance is relatively new and its potential still to explore. The three essays composing my thesis propose to use and extend this setting to study investors behavior and investment strategies in a market where crashes and sharp windfalls are likely to occur. In the first paper, the preferences of a representative agent, relative to time varying positive and negative extremal thresholds are modelled and estimated. A new utility function that conciliates between expected utility maximization and tail-related performance measures is proposed. The model estimation shows that the representative agent preferences reveals a significant level of crash aversion and lottery-pursuit. Assuming a single risky asset economy the proposed specification is able to reproduce some of the distributional features exhibited by financial return series. The second part proposes and illustrates a preference-based asset allocation model taking into account investors crash aversion. Using the skewed t distribution, optimal allocations are characterized as a resulting tradeoff between the distribution four moments. The specification highlights the preference for odd moments and the aversion for even moments. Qualitatively, optimal portfolios are analyzed in terms of firm characteristics and in a setting that reflects real-time asset allocation, a systematic over-performance is obtained compared to the aggregate stock market. Finally, in my third article, dynamic option-based investment strategies are derived and illustrated for investors presenting downside loss aversion. The problem is solved in closed form when the stock market exhibits stochastic volatility and jumps. The specification of downside loss averse utility functions allows corresponding terminal wealth profiles to be expressed as options on the stochastic discount factor contingent on the loss aversion level. Therefore dynamic strategies reduce to the replicating portfolio using exchange traded and well selected options, and the risky stock.

An empirical analysis of wealth taxation: equity Vs.tax compliance

Capital taxation is currently under debate, basically due to problems of administrative control and proper assessment of the levied assets. We analyze both problems focusing on a capital tax, the annual wealth tax (WT), which is only applied in five OECD countries, being Spain one of them. We concentrate our analysis on top 1% adult population, which permits us to describe the evolution of wealth concentration in Spain along 1983-2001. On average top 1% holds about 18% of total wealth, which rises to 19% when tax incompliance and under-assessment is corrected for housing, the main asset. The evolution suggests wealth concentration has risen. Regarding WT, we analyze whether it helps to reduce wealth inequality or, on the contrary, it reinforces vertical inequity (due to especial concessions) and horizontal inequity (due to the de iure and to de facto different treatment of assets). We analyze in detail housing and equity shares. By means of a time series analysis, we relate the reported values with reasonable price indicators and proxies of the propensity to save. We infer net tax compliance is extremely low, which includes both what we commonly understand by (gross) tax compliance and the degree of under-assessment due to fiscal legislation (for housing). That is especially true for housing, whose level of net tax compliance is well below 50%. Hence, we corroborate the difficulties in taxing capital, and so cast doubts on the current role of the WT in Spain in reducing wealth inequality.

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.

Can a Lucas model with habit generate realistic conditional volatility in exchange rate returns?

In this paper, we attempt to give a theoretical underpinning to the well established empirical stylized fact that asset returns in general and the spot FOREX returns in particular display predictable volatility characteristics. Adopting Moore and Roche s habit persistence version of Lucas model we nd that both the innovation in the spot FOREX return and the FOREX return itself follow "ARCH" style processes. Using the impulse response functions (IRFs) we show that the baseline simulated FOREX series has "ARCH" properties in the quarterly frequency that match well the "ARCH" properties of the empirical monthly estimations in that when we scale the x-axis to synchronize the monthly and quarterly responses we find similar impulse responses to one unit shock in variance. The IRFs for the ARCH processes we estimate "look the same" with an approximately monotonic decreasing fashion. The Lucas two-country monetary model with habit can generate realistic conditional volatility in spot FOREX return.

On the Relationship between Market Power and Bank Risk Taking

We analyse risk-taking behaviour of banks in the context of spatial competition. Banks mobilise unsecured deposits by offering deposit rates, which they invest either in a prudent or a gambling asset. Limited liability along with high return of a successful gamble induce moral hazard at the bank level. We show that when the market power is low, banks invest in the gambling asset. On the other hand, for sufficiently high levels of market power, all banks choose the prudent asset to invest in. We further show that a merger of two neighboring banks increases the likelihood of prudent behaviour. Finally, introduction of a deposit insurance scheme exacerbates banks’ moral hazard problem.

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.

Hawtreyan “Credit Deadlock” or Keynesian “Liquidity Trap”? Lessons for Japan from the Great Depression

This paper outlines the ideas of Ralph Hawtrey and Lauchlin Currie on the need for monetised fiscal deficit spending in 1930s USA to combat the deep depression into which the economy had been allowed to sink. In such exceptional circumstances of “credit deadlock” in which banks were afraid to lend and households and business afraid to borrow, the deadlock could best be broken through the spending of new money into circulation via large fiscal deficits. This complementarity of fiscal and monetary policy was shown to be essential, and as such indicates the potential power of monetary policy – in contrast to the Keynesian “liquidity trap” view that it is powerless This lesson was not learned by the Japanese authorities in their response to the asset price collapse of 1991-92, resulting in a lost decade as ballooning fiscal deficits were neutralised throughout the 1990s by unhelpfully tight monetary policy with the Bank of Japan refusing to monetise the deficits.

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.

An investigation of customer order flow in the foreign exchange market

This paper examines the effect that heterogeneous customer orders flows have on exchange rates by using a new, and the largest, proprietary dataset of weekly net order flow segmented by customer type across nine of the most liquid currency pairs. We make several contributions. Firstly, we investigate the extent to which customer order flow can help to explain exchange rate movements over and above the influence of macroeconomic variables. Secondly, we address the issue of whether order flows contain (private) information which explain exchange rates changes. Thirdly, we look at the usefulness of order flow in forecasting exchange rate movements at longer horizons than those generally considered in the microstructure literature. Finally we address the question of whether the out-of-sample exchange rate forecasts generated by order flows can be employed profitably in the foreign exchange markets

Learning about Risk and Return: A Simple Model of Bubbles and Crashes

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock’s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents’ estimates of risk.

The Rise and Fall of the ABS Market

The nancial crisis has raised some concern about the quality of information available on some traded assets on the securities markets to market participants and regulators. Asset-backed securitization in general got partial blame for the paucity of liquidity on bank balance sheets and the consequent credit crunch. After the Asset-Backed Security (ABS) market fell to near inactivity in 2009, the US federal government's Term Asset-Backed Securities Loan Facility (TALF) provided backing and a boost to the issuance of asset-backed securitization. In this market condition, given the nature of ABS, it is di¢ cult for them not to be relatively illiquid, and this has resulted in unacceptable levels of market risk for most investors. Their liquidity before the crisis was driven by a market in continuous expansion, fed by Special Purpose Vehicle (SPV), Conduits, and other low capitalized term-transformation vehicles. Nowadays, the industry is concerned with the ongoing ABS reforms and how these will be implemented. This article reviews the ABS market in the last decade and the possible consequences of the recent regulatory proposals. It proposes a retention policy and the institution of a new nancial body to supervise the quality of the security in an ABS pool, its liquidity, and the model risk implied by the issuer's valuation model.

A Producer Theory with Business Risks

In this paper, we consider a producer who faces uninsurable business risks due to incomplete spanning of asset markets over stochastic goods market outcomes, and examine how the presence of the uninsurable business risks affects the producer's optimal pricing and production behaviours. Three key (inter-related) results we find are: (1) optimal prices in goods markets comprise ‘markup’ to the extent of market power and ‘premium’ by shadow price of the risks; (2) price inertia as we observe in data can be explained by a joint work of risk neutralization motive and marginal cost equalization condition; (3) the relative responsiveness of risk neutralization motive and marginal cost equalization at optimum is central to the cyclical variation of markups, providing a consistent explanation for procyclical and countercyclical movements. By these results, the proposed theory of producer leaves important implications both micro and macro, and both empirical and theoretical.

Why do UK banks securitize?

The eight years from 2000 to 2008 saw a rapid growth in the use of securitization by UK banks. We aim to identify the reasons that contributed to this rapid growth. The time period (2000 to 2010) covered by our study is noteworthy as it covers the pre- financial crisis credit-boom, the peak of the fi nancial crisis and its aftermath. In the wake of the financial crisis, many governments, regulators and political commentators have pointed an accusing finger at the securitization market - even in the absence of a detailed statistical and economic analysis. We contribute to the extant literature by performing such an analysis on UK banks, focussing principally on whether it is the need for liquidity (i.e. the funding of their balance sheets), or the desire to engage in regulatory capital arbitrage or the need for credit risk transfer that has led to UK banks securitizing their assets. We show that securitization has been signi ficantly driven by liquidity reasons. In addition, we observe a positive link between securitization and banks credit risk. We interpret these latter findings as evidence that UK banks which engaged in securitization did so, in part, to transfer credit risk and that, in comparison to UK banks which did not use securitization, they had more credit risk to transfer in the sense that they originated lower quality loans and held lower quality assets. We show that banks which issued more asset-backed securities before the financial crisis suffered more defaults after the financial crisis.

Central banks and house prices in the run-up to the crisis

The financial crisis and the role played within it by fluctuations in house prices has reopened the debate about whether monetary policy should respond to asset prices. This paper investigates how the central banks of the euro area, the UK and the US considered, understood and responded to the trends in house prices in the six or seven years preceding the crisis, and how they have analysed those developments since the crisis. It suggests that these central banks, particularly the Anglo-Saxon ones, might have been able to take some useful action if they had devoted more intellectual resources to analysing the possible misalignments of house prices and been willing to act on them.