2024-03-28T14:56:28Zhttps://escholarship.org/oaioai:escholarship.org:ark:/13030/qt7s57834n2013-07-24T23:03:56Zqt7s57834nQuantifying the Impact of Leveraging and Diversification on Systemic RiskTasca, PaoloMavrodiev, PavlinSchweitzer, Frank2013-03-22Excessive leverage, i.e. the abuse of debt financing, is considered one of the primary factors in the default of financial institutions. Systemic risk results from correlations between individual default probabilities that cannot be considered independent. Based on the structural framework by Merton (1974), we discuss a model in which these correlations arise from overlaps in banks' portfolios. Portfolio diversification is used as a strategy to mitigate losses from investments in risky projects. We calculate an optimal level of diversification that has to be reached for a given level of excessive leverage to still mitigate an increase in systemic risk. In our model, this optimal diversification further depends on the market size and the market conditions (e.g. volatility). It allows to distinguish between a safe regime, in which excessive leverage does not result in an increase of systemic risk, and a risky regime, in which excessive leverage cannot be mitigated leading to an increased systemic risk. Our results are of relevance for financial regulators.Systemic RiskLeverageDiversificationapplication/pdfCC-BY-SAeScholarship, University of Californiahttps://escholarship.org/uc/item/7s57834narticleoai:escholarship.org:ark:/13030/qt5q05g9pt2012-01-23T20:29:15Zqt5q05g9ptSearch Costs: The Neglected Spread ComponentFlood, Mark D.Huisman, RonaldKoedijk, Kees G.Lyons, Richard K.2012-01-23Dealers need to search for quotes in many of the world's largest markets (such as spot foreign exchange, US government bonds, and the London Stock Exchange). This search affects trading cost. We estimate the share of total trading cost attributable to search. Our experiments show that the share is large -- roughly one-third of the effective spread. Past work on estimating spread components typically omits the search component. Our estimates suggest this omission is important.trading costtradersquotesapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/5q05g9ptarticleoai:escholarship.org:ark:/13030/qt8sd393sj2011-07-02T14:50:46Zqt8sd393sjHOw Do Firms Choose Their Leaders? An Empirical InvestigationCantillo, MiguelWright, Julian2000-02-01This article investigates which companies finance themselves through intermediaries and which borrow directly from arm's length investors. Our empirical results show that large companies with abundant cash and collateral tap credit markets directly; these markets cater to safe and profitable industries, and are most active when riskless rates or intermediary earnings are low. We show that determinants of lender selection sharpen during investment downturns and that there are substantial asymmetries in the way firms enter and exit capital markets. These results support a theoretical framework where intermediaries have better reorganizational skills but a higher opportunity cost of capital than bondholders.application/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/8sd393sjarticleoai:escholarship.org:ark:/13030/qt8647j8gq2011-07-02T14:50:29Zqt8647j8gqHousing Return and Construction CyclesSpiegel, Matthew1999-01-01This paper presents a model that derives both housing returns and housing construction patterns from events in the real economy. The value of a home, unlike the value of many other financial assets, depends upon the care its owner exerts on upkeep. Within the model banks respond to this moral hazard problem by restricting the size of the loans they are willing to issue. As a result housing prices no longer follow a random walk, but rather are tied to changes in the endowment process which are both predictable and time varying. That is, in some states of nature homeowners expect to earn an above market return on their housing purchase while in others they expect to earn a below market return. Developers in the model are fully cognizant of the housing price process and react accordingly. The result is a construction cycle that seems at odds with conventional wisdom. When endowments are growing quickly (a city with a rapidly growing economy) housing prices exhibit above market expected returns. However, since housing prices are expected to increase faster than the rate of interest, developers delay construction. Thus, during periods of rapid expected economic growth housing construction ceases until one reaches the crest whereupon development booms. In response housing supplies dwindle during economic booms (as homes deteriorate) and then increase when the boom ends.housing returnsapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/8647j8gqarticleoai:escholarship.org:ark:/13030/qt6sq4c6g02011-07-02T14:50:24Zqt6sq4c6g0The Role of a Corporate Bond Market in an Economy -- and in Avoiding CrisesHakansson, Nils H.1999-06-01While much attention has been focused on the optimal ratio of a firm's debt to equity, the "optimal" or best balance between bond financing and (longer-term) bank financing has scarcely been addressed. This essay examines the principal differences between an economy with a well-developed corporate bond market free from government interference and an economy in which bank financing plays a central role (as in East Asia). When a full-fledged corporate bond market is present, market forces have a much greater opportunity to assert themselves, thereby reducing systemic risk and the probability of a crisis. This is because such an environment is associated with greater accounting transparency, a large community of financial analysts, respected rating agencies, a wide range of corporate debt securities and derivatives demanding sophisticated credit analysis, and efficient procedures for corporate reorganization and liquidation. In addition, the richness of available securities will tend to enhance economic welfare, and the market forces at work on the wide array of bond prices are likely to have a strong spillover effect on the health of the banking system as well.G21G28G31G32G33G34application/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/6sq4c6g0articleoai:escholarship.org:ark:/13030/qt0dh1c16w2011-07-02T14:50:19Zqt0dh1c16wOrder Flow and Exchange Rate DynamicsEvans, Martin D.Lyons, Richard K.1999-08-01Macroeconomic models of nominal exchange rates perform poorly. In sample, R 2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a naïve random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure-order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R 2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$ spot market as a whole, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 1 pfennig.Order FlowExchange RateMicrostructureFundamentalsand Forecastingapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/0dh1c16warticleoai:escholarship.org:ark:/13030/qt7g67n9112011-07-02T14:50:14Zqt7g67n911Credit Derivatives in Banking: Useful Tools for Managing Risk?Duffee, Gregory R.Zhou, Chunseng1999-11-01We model the effects on banks of the introduction of a market for credit derivatives; in particular, credit-default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools such as loan sales without recourse, these instruments make it easier for banks to circumvent the "lemons" problem caused by banks' superior information about the credit quality of their loans. However, we find that the introduction of a credit-derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down.credit-default swapsbank loansloan salesasymmetric informationG21D82application/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/7g67n911articleoai:escholarship.org:ark:/13030/qt0fw6k0hm2011-07-02T14:50:10Zqt0fw6k0hmOptimal Portfolio Management with Transactions Costs and Capital Gains TaxesLeland, Hayne E.1999-12-01We examine the optimal trading strategy for an investment fund which in the absence of transactions costs would like to maintain assets in exogenously fixed proportions, e.g. 60/30/10 in stocks, bonds and cash. Transactions costs are assumed to be proportional, but may differ with buying and selling, and may include a (positive) capital gains tax component.We show that the optimal policy involves a no-trade region about the target stock proportions. As long as the actual proportions remain inside this region, no trading should occur. When proportions are outside the region, trading should be undertaken to move the ratio to the region's boundary. We compute the optimal multi-asset no-trade region and resulting annual turnover and tracking error of the optimal strategy. Almost surely, the strategy will require trading just one risky asset at any moment, although which asset is traded varies stochastically through time. Compared to the current practice of periodic rebalancing of all assets to their target proportions, the optimal strategy will reduce turnover by almost 50%.The optimal response to a capital gains tax is to allow proportions to substantially exceed their target levels before selling. When an asset's proportion exceeds a critical level, selling should occur to bring it back to that critical level. Capital gains taxes lead to lower optimal initial investment levels. Similarly, it is optimal to invest less initially in asset classes that have high transactions costs, such as emerging markets.trading strategytransactions costscapital gains taxapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/0fw6k0hmarticleoai:escholarship.org:ark:/13030/qt0p34c6402011-07-02T14:50:04Zqt0p34c640Corporate Diversification and AgencyHermalin, Benjamin E.Katz, Michael2000-01-02Firms undertake a variety of actions to reduce risk through diversification, including entering diverse lines of business, taking on project partners, and maintaining portfolios of risky projects such as R&D or natural resource exploration. By a well-known argument, securities holders do not directly benefit from risk-reducing corporate diversification when they can replicate this diversification on their own. Moreover, shareholders should be risk neutral with respect to the unsystematic risk that is associated with many research projects. Some have argued that corporate risk reduction may be of value, or can otherwise be explained by, the agency relationship between securities holders and managers. We argue that the value of diversification strategies in an agency relationship derives not from its effects on risk, but rather from its effects on the principal's information about the agent's actions. We demonstrate by example that diversification activities may increase or decrease the principal's information, depending on the particular structure of the activitydiversificationprincipal-agent relationshipapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/0p34c640articleoai:escholarship.org:ark:/13030/qt22q318mh2011-07-02T14:50:00Zqt22q318mhRational Markets: Yes or No? The Affirmative CaseRubinstein, Mark2000-06-01This paper presents the logic behind the increasingly neglected proposition that prices set in developed financial markets are determined as if all investors are rational. It contends that realistically, market rationality needs to be defined so as to allow investors to be uncertain about the characteristics of other investors in the market. It also argues that investor irrationality, to the extent it affects prices, is particularly likely to be manifest through overconfidence, which in turn is likely to make the market in an important sense too efficient, rather than less efficient, in reflecting information. To illustrate, the paper ends by re-examining some of the most serious evidence against market rationality: excess volatility, the risk premium puzzle, the size anomaly, calendar effects and the 1987 stock market crashmarket rationalityvolatilityapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/22q318mharticleoai:escholarship.org:ark:/13030/qt7pb301tr2011-07-02T12:48:40Zqt7pb301trMeasuring Tail Thickness under GARCH and an Application to Extremal Exchange Rate ChangesWagner, NiklasMarsh, Terry A.2003-06-01Accurate modeling of extremal price changes is vital to financial risk management. We examine the small sample properties of adaptive tail index estimators under the class of student-t marginal distribution functions including GARCH and propose a model-based bias-corrected estimation approach. Our simulation results indicate that bias strongly relates to the underlying model and may be positively as well as negatively signed. The empirical study of daily exchange rate changes reveals substantial differences in measured tail-thickness due to small sample bias. As a consequence, high quantile estimation may lead to a substantial underestimation of tail risk.fat tailstail indexstationary marginal distributionGARCHHill estimatorforeign exchangeapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/7pb301trarticleoai:escholarship.org:ark:/13030/qt2qb613r52011-07-02T12:48:33Zqt2qb613r5An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?Downing, ChrisStanton, RichardWallace, Nancy E.2003-04-01Mortgage-backed securities, with their relative structural simplicity and their lack of recovery rate uncertainty if default occurs, are particularly suitable for developing and testing risky debt valuation models. In this paper, we develop a two-factor structural mortgage pricing model in which rational mortgage-holders endogenously choose when to prepay and default subject to i. explicit frictions (transaction costs) payable when terminating their mortgages, ii. exogenous background terminations, and iii. a credit related impact of the loan-to-value ratio (LTV) on prepayment. We estimate the model using pool-level mortgage termination data for Freddie Mac Participation Certificates, and find that the effect of the house price factor on the results is both statistically and economically significant. Out-of-sample estimates of MBS prices produce option adjusted spreads of between 5 and 25 basis points, well within quoted values for these securities.residential mortgage-backed securitymortgage pricing modelbondsrisky debtFreddie Macapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/2qb613r5articleoai:escholarship.org:ark:/13030/qt3bw450n02011-07-02T12:48:28Zqt3bw450n0On the Relation Between Binomial and Trinomial Option Pricing ModelsRubinstein, Mark2000-05-01This paper shows that the binomial option pricing model, suitably parameterized, is a special case of the explicit finite difference method.binomial option pricing modeltrinomialexplicit finite differenceapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/3bw450n0articleoai:escholarship.org:ark:/13030/qt1z87z9222011-07-02T12:48:22Zqt1z87z922Return-Volume Dependence and Extremes in International Equity MarketsWagner, NiklasMarsh, Terry A.2003-09-02This paper reconsiders return-volume dependence for the U.S. and six international equity markets. We contribute to previous work by proposing surprise volume as a new proxy for private information flow and apply extreme value theory in studying dependence for large volume and return, i.e. under situations of market stress. Results from a GARCH-M model indicate that surprise volume is superior in explaining conditional variance and reveals a positive market risk premium. Under conditions of market stress, the return-volume dependence is weaker, albeit mostly significant. The results for the U.S. market are most pronounced in that surprise volume explains ARCH- as well as leverage-effects and, under market stress, the return-volume dependence remains significant and symmetric. For the European and Asian markets, however, the dependence is weaker with asymmetry under market stress, i.e. small minimal returns show lower volume dependence than large maximal returns. We argue that our results are more consistent with a Gennotte and Leland (1990) misinterpretation hypothesis for market crashes than with cascade or behavioral explanations which associate high volume with steep price declines.Trading volumereturn-volume dependencemixture of distributions hypothesisextreme returnsbivariate extremal dependencemarket crashesapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/1z87z922articleoai:escholarship.org:ark:/13030/qt2651k8f52011-07-02T11:12:29Zqt2651k8f5On Adaptive Tail Index Estimation for Financial Return ModelsWagner, NiklasMarsh, Terry2000-11-01Estimation of the tail index of stationary, fat-tailed return distributions is non-trivial since the well-known Hill estimator is optimal only under iid draws from an exact Pareto model. We provide a small sample simulation study of recently suggested adaptive estimators under ARCH-type dependence. The Hill estimator's performance is found to be dominated by a ratio estimator. Dependence increases estimation error which can remain substantial even in larger data sets. As small sample bias is related to the magnitude of the tail index, recent standard applications may have overestimated (underestimated) the risk of assets with low (high) degrees of fat-tailedness.fat-tailstail index of stationary marginal distributionsHill estimatorminimal AMSEapplication/pdfpubliceScholarship, University of Californiahttps://escholarship.org/uc/item/2651k8f5article