Three essays on bankruptcy risk

Abstract Market prices of corporate bond spreads and of credit default swap (CDS) rates do not match each other. In this paper, we argue that the liquidity premium, the cheapest-to-deliver (CTD) option and actual market segmentation explain the pricing differences. Using the European transaction data from Reuters and Bloomberg, we estimate the liquidity premium that is time- varying and firm-specific. We show that when time-dependent liquidity premiums are considered, corporate bond spreads and CDS rates behave in a much closer way than previous studies have shown. We find that high equity volatility drives pricing differences that can be explained by the CTD option.

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.

Inequality and Risk-Taking Behaviour

This paper investigates social influences on attitudes to risk and offers an evolutionary explanation of risk-taking by young low-ranked males. Becker, Murphy and Werning (2005) found that individuals about to participate in a status tournament may take fair gambles even though they are risk averse in both wealth and status. Here their model is generalised by use of the insight of Hopkins and Kornienko (2010) that in a tournament or status competition one can consider equality in terms of the status or rewards available as well as in initial endowments. While Becker et al. found that risk-taking is increasing in the equality of initial endowments, it is found here that it is increasing in the inequality of rewards in the tournament. Further, it is shown that the poorest will be risk loving if the lowest level of status awarded is sufficiently low. Thus, the disadvantaged in society rationally engage in risky behavior when social rewards are sufficiently unequal. Finally, as greater inequality in terms of social status induces gambling, it can cause greater inequality of wealth.

Universal banking, competition and risk in a macro model

A stylized macroeconomic model is developed with an indebted, heterogeneous Investment Banking Sector funded by borrowing from a retail banking sector. The government guarantees retail deposits. Investment banks choose how risky their activities should be. We compared the benefits of separated vs. universal banking modelled as a vertical integration of the retail and investment banks. The incidence of banking default is considered under different constellations of shocks and degrees of competitiveness. The benefits of universal banking rise in the volatility of idiosyncratic shocks to trading strategies and are positive even for very bad common shocks, even though government bailouts, which are costly, are larger compared to the case of separated banking entities. The welfare assessment of the structure of banks may depend crucially on the kinds of shock hitting the economy as well as on the efficiency of government intervention.

Aggregate and welfare effects of long run inflation risk under inflation and price-level targeting

This paper presents a DSGE model in which long run inflation risk matters for social welfare. Aggregate and welfare effects of long run inflation risk are assessed under two monetary regimes: inflation targeting (IT) and price-level targeting (PT). These effects differ because IT implies base-level drift in the price level, while PT makes the price level stationary around a target price path. Under IT, the welfare cost of long run inflation risk is equal to 0.35 percent of aggregate consumption. Under PT, where long run inflation risk is largely eliminated, it is lowered to only 0.01 per cent. There are welfare gains from PT because it raises average consumption for the young and lowers consumption risk substantially for the old. These results are strongly robust to changes in the PT target horizon and fairly robust to imperfect credibility, fiscal policy, and model calibration. While the distributional effects of an unexpected transition to PT are sizeable, they are short-lived and not welfare-reducing.

Low-frequency drug-resistant HIV-1 and risk of virological failure to first-line NNRTI-based ART: a multicohort European case-control study using centralized ultrasensitive 454 pyrosequencing.

OBJECTIVES: It is still debated if pre-existing minority drug-resistant HIV-1 variants (MVs) affect the virological outcomes of first-line NNRTI-containing ART. METHODS: This Europe-wide case-control study included ART-naive subjects infected with drug-susceptible HIV-1 as revealed by population sequencing, who achieved virological suppression on first-line ART including one NNRTI. Cases experienced virological failure and controls were subjects from the same cohort whose viraemia remained suppressed at a matched time since initiation of ART. Blinded, centralized 454 pyrosequencing with parallel bioinformatic analysis in two laboratories was used to identify MVs in the 1%-25% frequency range. ORs of virological failure according to MV detection were estimated by logistic regression. RESULTS: Two hundred and sixty samples (76 cases and 184 controls), mostly subtype B (73.5%), were used for the analysis. Identical MVs were detected in the two laboratories. 31.6% of cases and 16.8% of controls harboured pre-existing MVs. Detection of at least one MV versus no MVs was associated with an increased risk of virological failure (OR = 2.75, 95% CI = 1.35-5.60, P = 0.005); similar associations were observed for at least one MV versus no NRTI MVs (OR = 2.27, 95% CI = 0.76-6.77, P = 0.140) and at least one MV versus no NNRTI MVs (OR = 2.41, 95% CI = 1.12-5.18, P = 0.024). A dose-effect relationship between virological failure and mutational load was found. CONCLUSIONS: Pre-existing MVs more than double the risk of virological failure to first-line NNRTI-based ART.

Unemployment Risk and Wage Differentials

Workers in less secure jobs are often paid less than identical-looking workers in more secure jobs. We show that this lack of compensating differentials for unemployment risk can arise in equilibrium when all workers are identical and firms differ only in job security (i.e. the probability that the worker is not sent into unemployment). In a setting where workers search for new positions both on and off the job, the worker's marginal willingness to pay for job security is endogenous: it depends on the behavior of all firms in the labor market and increases with the rent the employing firm leaves to the worker. We solve for the labor market equilibrium, finding that wages increase with job security for at least all firms in the risky tail of the distribution of firm-level unemployment risk. Meanwhile, unemployment becomes persistent for low-wage and unemployed workers, a seeming pattern of 'unemployment scarring' created entirely by firm heterogeneity. Higher in the wage distribution, workers can take wage cuts to move to more stable employment.

Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive

We study a business cycle model in which a benevolent fiscal authority must determine the optimal provision of government services, while lacking credibility, lump-sum taxes, and the ability to bond finance deficits. Households and the fiscal authority have risk sensitive preferences. We find that outcomes are affected importantly by the household's risk sensitivity, but not by the fiscal authority's. Further, while household risk-sensitivity induces a strong precautionary saving motive, which raises capital and lowers the return on assets, its effects on fluctuations and the business cycle are generally small, although more pronounced for negative shocks. Holding the stochastic steady state constant, increases in household risk-sensitivity lower the risk-free rate and raise the return on equity, increasing the equity premium. Finally, although risk-sensitivity has little effect on the provision of government services, it does cause the fiscal authority to lower the income tax rate. An additional contribution of this paper is to present a method for computing Markov-perfect equilibria in models where private agents and the government are risk-sensitive decisionmakers.

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.

Comparative Statics of Asset Prices: the effect of other assets' risk

Currently, financial economics is unable to predict changes in asset prices with respect to changes in the underlying risk factors, even when an asset's dividend is independent of a given factor. This paper takes steps towards addressing this issue by highlighting a crucial component of wealth effects on asset prices hitherto ignored by the literature. Changes in wealth do not only alter an agents risk aversion, but also her perceived 'riskiness' of a security. The latter enhances significantly the extent to which market- clearing leads to endogenously-generated correlation across asset prices, over and above that induced by correlation between payoffs, giving the appearance of 'contagion.'

Modeling Dependence Structure and Forecasting Portfolio Value-at-Risk with Dynamic Copulas

We study the asymmetric and dynamic dependence between financial assets and demonstrate, from the perspective of risk management, the economic significance of dynamic copula models. First, we construct stock and currency portfolios sorted on different characteristics (ex ante beta, coskewness, cokurtosis and order flows), and find substantial evidence of dynamic evolution between the high beta (respectively, coskewness, cokurtosis and order flow) portfolios and the low beta (coskewness, cokurtosis and order flow) portfolios. Second, using three different dependence measures, we show the presence of asymmetric dependence between these characteristic-sorted portfolios. Third, we use a dynamic copula framework based on Creal et al. (2013) and Patton (2012) to forecast the portfolio Value-at-Risk of long-short (high minus low) equity and FX portfolios. We use several widely used univariate and multivariate VaR models for the purpose of comparison. Backtesting our methodology, we find that the asymmetric dynamic copula models provide more accurate forecasts, in general, and, in particular, perform much better during the recent financial crises, indicating the economic significance of incorporating dynamic and asymmetric dependence in risk management.

Picking the Right Budget Constraint for Scotland

This position paper considers the devolution of further fiscal powers to the Scottish Parliament in the context of the objectives and remit of the Smith Commission. The argument builds on our discussion of fiscal decentralization made in our previous published work on this topic. We ask what sort of budget constraint the Scottish Parliament should operate with. A soft budget constraint (SBC) allows the Scottish Parliament to spend without having to consider all of the tax and, therefore, political consequences, of that spending, which is effectively the position at the moment. The incentives to promote economic growth through fiscal policy – on both the tax and spending sides are weak to non-existent. This is what the Scotland Act, 1998, and the continuing use of the Barnett block grant, gave Scotland. Now other budget constraints are being discussed – those of the Calman Commission (2009) and the Scotland Act (2012), as well as the ones offered in 2014 by the various political parties – Scottish Conservatives, Scottish Greens, Scottish Labour, the Scottish Liberal Democrats and the Scottish Government. There is also the budget constraint designed by the Holtham Commission (2010) for Wales that could just as well be used in Scotland. We examine to what extent these offer the hard budget constraint (HBC) that would bring tax policy firmly into the realm of Scottish politics, asking the Scottish electorate and Parliament to consider the costs to them of increasing spending in terms of higher taxes; or the benefits to them of using public spending to grow the tax base and own-sourced taxes? The hardest budget constraint of all is offered by independence but, as is now known, a clear majority of those who voted in the referendum did not vote for this form of budget constraint. Rather they voted for a significant further devolution of fiscal powers while remaining within a political and monetary union with the rest of the UK, with the risk pooling and revenue sharing that this implies. It is not surprising therefore that none of the budget constraints on offer, apart from the SNP’s, come close to the HBC of independence. However, the almost 25% fall in the price of oil since the referendum, a resource stream so central to the SNP’s economic policy making, underscores why there is a need for a trade off between a HBC and risk pooling and revenue sharing. Ranked according to the desirable characteristic of offering something approaching a HBC the least desirable are those of the Calman Commission, the Scotland Act, 2012, and Scottish Labour. In all of these the ‘elasticity’ of the block grant in the face of failure to grow the Scottish tax base is either not defined or is very elastic – meaning that the risk of failure is shuffled off to taxpayers outside of Scotland. The degree of HBC in the Scottish Conservative, Scottish Greens and Scottish Liberal Democrats proposals are much more desirable from an economic growth point of view, the latter even embracing the HBC proposed by the Holtham Commission that combines serious tax policy with welfare support in the long-run. We judge that the budget constraint in the SNP’s proposals is too hard as it does not allow for continuation of the ‘welfare union’ in the UK. We also consider that in the case of a generalized UK economic slow requiring a fiscal stimulus that the Scottish Parliament be allowed increased borrowing to be repaid in the next economic upturn.

Unemployment Risk and Wage Differentials

Workers in less-secure jobs are often paid less than identical-looking workers in more secure jobs. We show that this lack of compensating differentials for unemployment risk can arise in equilibrium when all workers are identical and firms differ only in job security (i.e. the probability that the worker is not sent into unemployment). In a setting where workers search for new positions both on and off the job, the worker’s marginal willingness to pay for job security is endogenous, increasing with the rent received by a worker in his job, and depending on the behavior of all firms in the labor market. We solve for the labor market equilibrium and find that wages increase with job security for at least all firms in the risky tail of the distribution of firm-level unemployment risk. Unemployment becomes persistent for low-wage and unemployed workers, a seeming pattern of ‘unemployment scarring’ created entirely by firm heterogeneity. Higher in the wage distribution, workers can take wage cuts to move to more stable employment.

Modeling Dependence Structure and Forecasting Market Risk with Dynamic Asymmetric Copula

We investigate the dynamic and asymmetric dependence structure between equity portfolios from the US and UK. We demonstrate the statistical significance of dynamic asymmetric copula models in modelling and forecasting market risk. First, we construct “high-minus-low" equity portfolios sorted on beta, coskewness, and cokurtosis. We find substantial evidence of dynamic and asymmetric dependence between characteristic-sorted portfolios. Second, we consider a dynamic asymmetric copula model by combining the generalized hyperbolic skewed t copula with the generalized autoregressive score (GAS) model to capture both the multivariate non-normality and the dynamic and asymmetric dependence between equity portfolios. We demonstrate its usefulness by evaluating the forecasting performance of Value-at-Risk and Expected Shortfall for the high-minus-low portfolios. From back-testing, e find consistent and robust evidence that our dynamic asymmetric copula model provides the most accurate forecasts, indicating the importance of incorporating the dynamic and asymmetric dependence structure in risk management.