Research Program in Finance

Macroeconomic 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.

We 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.

Firms 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 activity