contagion as a wealth effect financial contagion is described as a wealth effect in a continuous time model with two risky assets and three types of traders noise traders trade randomly in one market long term investors provide liquidity using a linear rule based on fundamentals convergence traders with logarithmic utility trade optimally in both markets asset price dynamics are endogenously determined numerically as functions of endogenous wealth and exogenous noise when convergence traders lose money they liquidate positions in both markets this creates contagion in that returns become more volatile and more correlated contagion reduces benefits from portfolio diversification and raises issues for risk management during the f inancial panic associated with the default of the russian government in august 1998 and the subsequent collapse of the hedge fund long term capital management numerous hedge funds banks and securities firms tried simultaneously to reduce exposures to a variety of financial instruments such as russian bonds brazilian stocks u s mortgages spreads between on therun and off the run government securities and spreads between swaps and u s treasuries although the fundamental values of these positions would appear to have little correlation during this financial crisis the asset prices in these markets exhibited the following common empirical pattern 1 financial intermediaries suffered losses as prices moved against their positions 2 market depth and liquidity decreased simultaneously in several markets 3 the volatility of prices increased simultaneously in several markets and

indeterminacy of stationary equilibrium in stochastic overlapping generations models abstract in this paper we consider the local uniqueness properties of stationary rational expectations equilibria ree in a stochastic overlapping generations olg model it is known that in non stochastic olg models steady state equilibria are locally isolated although there may exist indeterminate non stationary perfect foresight equilibria we show by construction that in the stochastic model even stationary equilibrium may be indeterminate we also show that this result is robust in the sense that there exists a non empty open set of economies for which the result is true

financial markets the real economy and self fulfilling uncertainties we develop a model of informational interdependence between financial markets and the real economy linking economic uncertainty to information production and aggregate economic activities in general equilibrium the mutual learning between financial markets and the real economy creates a strategic complementarity in their information production leading to self fulfilling surges in economic uncertainties in a dynamic setting our model characterizes self fulfilling uncertainty traps with two steady state equilibria and a two stage economic crisis in transitional dynamics

can information heterogeneity explain the exchange rate determination puzzle empirical evidence shows that most exchange rate volatility at short to medium horizons is related to order flow and not to macroeconomic variables we introduce symmetric information dispersion about future macroeconomic fundamentals in a dynamic rational expectations model in order to explain these stylized facts consistent with the evidence the model implies that a observed fundamentals account for little of exchange rate volatility in the short to medium run b over long horizons the exchange rate is closely related to observed fundamentals c exchange rate changes are a weak predictor of future fundamentals and d the exchange rate is closely related to order flow

regulating asset price risk there has been a long debate about whether speculat ors are stabilizing or not we consider a model where speculators have a stabilizing role in normal times but may also provoke large risk pa nics the very feature that makes arbitrageurs liquidity providers in normal times namely their tolerance of risk enables a large inc rease in asset price risk during a financial panic we show that a polic y that discourages balance sheet risk reduces the magnitude of financi al panics as well as asset price risk in both normal and panic states

leverage cycles and the anxious economy ing opportunities for emerging economies their access to international markets has turned out to be very volatile with frequent periods of market closures even worse as we will show emerging economies with sound fundamentals are the ones that issue less debt during these closures the goal of this paper is to present a theory of asset pricing that will shed light on the problems of emerging assets like emerging markets that are not yet mature enough to be attractive to the general public their marginal buyers are liquidity constrained investors with small wealth relative to the whole economy who are also marginal buyers of other risky assets we will use our theory to argue that the periodic problems faced by emerging asset classes are sometimes symptoms of what we call a global anxious economy rather than of their own fundamental weaknesses

convergence trading with wealth effects an amplification mechanism in financial markets abstract i study convergence traders with logarithmic utility in a continuous time equilibrium model in general convergence traders reduce asset price volatility and provide liquidity by taking risky positions against noise trading however when an unfavorable shock causes them to suffer capital losses thus eroding their risk bearing capacity they liquidate their positions thereby amplifying the original shock in extreme circumstances this wealth effect causes convergence traders to be destabilizing in that they trade in exactly the same direction as noise traders this situation is consistent with the near collapse of long term capital management in 1998

optimal portfolio selection in a value at risk framework abstract in this paper we develop a portfolio selection model which allocates financial assets by maximising expected return subject to the constraint that the expected maximum loss should meet the value at risk limits set by the risk manager similar to the mean variance approach a performance index like the sharpe index is constructed furthermore when expected returns are assumed to be normally distributed we show that the model provides almost identical results to the mean variance approach we provide an empirical analysis using two risky assets us stocks and bonds the results highlight the influence of both non normal characteristics of the expected return distribution and the length of investment time horizon on the optimal portfolio selection

a macroeconomic model with a financial sector this paper studies a macroeconomic model in which financial experts borrow from less productive agents we pursue four sets of results i the economy is prone to instability and occasionally enters volatile episodes as volatility spikes agents precautionary motive increases depressing prices even further log linear approximations fail to capture these non linear effects that can cause economies to be significantly depressed for long periods of time ii endogenous risk during volatile episodes increases asset price correlations iii financial experts impose a negative externality on each other and on the labor sector by not maintaining adequate capital cushion and funding structure iv while risk sharing within the financial sector through securitization and derivatives contracts reduces many inefficiencies it can also amlify systemic risks

sudden spikes in global risk abstract recent episodes october 2008 may 2010 august 2011 have witnessed huge spikes in equity price risk implied volatility apart from their large size several features characterize these risk panics they are global phenomena shared among a broad set of countries there is substantial variation though in the extent to which individual countries are impacted while the impact bears little relation to financial linkages with the epicenter of the crisis in addition there is usually not a large shock to fundamentals that sets off these panics we provide an explanation for these risk panic features in the context of a two country model that allows for self fulfilling shifts in risk

multiple equilibria in a simple asset pricing model multiple stationary equilibria are often encountered in standard asset pricing models when one assumes negative exponential utility with gaussian uncertainty this paper demonstrates that there are exactly two stationary equilibria which are due solely to the presence of nonlinearities

a dynamic bank portfolio planning model with multiple scenarios multiple goals and changing priorities abstract the paper discusses a practical application of a two stage linear goal programming model to the management of the domestic and foreign currency denominated assets and liabilities of a large bank in finland the planning horizon includes three one year planning periods a number of alternative scenarios are used to describe uncertainty concerning future developments in these periods the scenarios are related to general economic conditions as well as the state of the domestic and foreign financial markets the bank is assumed to have multiple conflicting goals with different and changing priorities the goals deal with expected profits risk liquidity capital adequacy growth customer relationships and several other aspects of the bank s operations

endogenous market thinness and stock price volatility thin equity markets cannot accommodate temporary bulges of buy or sell orders without large price movements the resulting volatility can induce risk averse transactors who face transaction costs to desert these markets thus thinness and the related price volatility may become joint self perpetuating features of an equity market irrespective of the volatility of asset fundamentals if however appropriate incentive schemes are adopted to encourage entry by additional investors this vicious circle can be broken eventually shifting the market to a selfsustaining superior equilibrium characterized by a higher number of transactors lower price volatility and larger supply of the asset a number of empirical studies cohen et al 1976 telser and higimbotham 1977 pagano 1986 tauchen and pitts 1983 have found that thin speculative markets are ceteris paribus more volatile than deep ones a plausible explanation for this finding is that thin markets are generally characterized by small numbers of transactors per unit time and thus their prices are more sensitive to the impact of individual traders demand shocks conversely in deep markets transactors are so many that the uncorrelated demand shocks experienced by individual traders tend to offset each other and leave market prices largely unaffected while this suggests a rationale for the observed relationship between market size and price volatility it does so by taking market size as the exogenous factor however the volatility of a speculative market may feed back on its size in the sense that the high liquidation risk implied by very volatile prices can induce potential entrants to keep out of the market this paper shows that in a stock market with transaction costs this interaction between thinness and volatility can produce multiple steady state equilibria some characterized by low trade and high volatility and others by high trade and low volatility whether the market will settle in one equilibrium or another depends entirely on the expectations held by economic agents sections 2 and 3 the existence of these multiple bootstrap equilibria can be explained heuristically as follows each additional trader generates a positive externality for other actual or potential traders by decreasing the riskiness of the stock lower risk in turn tends to attract more investors with the effect of raising stock prices and inducing corporations to issue additional equity we thus have a feedback loop between market size and price volatility where market size is measured both along the dimension of the number of traders and along that of the total stock of equities if however investors face transactions costs in the stock market this positive feedback may fail to be operative if the volume of trade is expected to be small investors with relatively high transaction costs will abstain from trading thus the market

sunspot like effects of random endowments abstract random endowments can affect economic outcomes in two ways directly by affecting resources and indirectly by endogenously affecting expectations this second effect which we call a sunspot like effect allows prices to overreact to movements in fundamentals we prove that sunspot equilibria can be viewed as the limiting case of markets overreacting to small shocks to fundamentals two examples illustrate the theorem and show that sunspot like effects can be present even with significant shocks to fundamentals

how do us credit supply shocks propagate internationally a gvar approach abstract we study how us credit supply shocks are transmitted to other economies we use the recently developed gvar approach to model financial variables jointly with macroeconomic variables in 33 countries for the period 1983 2009 we experiment with inter country links based on bilateral trade portfolio investment foreign direct investment and banking exposures capturing both bilateral trade and financial exposures in a gvar fits the data better than using trade weights only we use sign restrictions on the short run impulse responses in the us model to identify the credit supply shocks we find that negative credit supply shocks have strong negative effects on us and foreign gdp credit and equity markets in several countries respond clearly to the shocks exchange rate responses are consistent with a flight to quality to the us dollar the credit supply shocks explain about a fifth of one year ahead output forecast error variance in the us and about a tenth in the euro area and the uk but considerably less elsewhere

bank funding risks risk aversion and the choice of futures hedging instrument currently theories of financial futures hedging are based on either a portfolio choice approach or a duration approach this article presents an alternative a firm theoretic model of bank behavior with financial futures assuming the bank is uncertain about cash cd interest rates and the quantity of cds it needs in the future expressions for the optimal futures hedge are derived under constant absolute risk aversion and constant relative risk aversion the performance of these two strategies is estimated from 19811983 using either the recently developed cd futures contract or the t bill futures contract these results are also compared with the performance of a portfolio choice strategy and a routine hedging strategy the analysis indicates that the cd futures market can serve a hedging purpose that is not served by the previously established t bill futures market the emergence and rapid growth of interest rate futures markets suggest that

self fulfilling risk panics abstract recent crises have seen large spikes in asset price risk we propose an explanation for such panics based on self fulfilling shifts in beliefs about risk a negative link between the curre

do liquidity measures measure liquidity abstract given the key role of liquidity in finance research identifying high quality proxies based on daily as opposed to intraday data would permit liquidity to be studied over relatively long timeframes and across many countries using new measures and widely employed measures in the literature we run horseraces of annual and monthly estimates of each measure against liquidity benchmarks our benchmarks are effective spread realized spread and price impact based on both trade and quote taq and rule 605 data we find that the new effective realized spread measures win the majority of horseraces while the amihud 2002 illiquidity and stock returns cross section and time series effects journal of financial markets 5 31 56 measure does well measuring price impact

a general model of the banking firm under conditions of monopoly uncertainty and recourse abstract we develop a stochastic programming model of the monopolistic competition banking firm it assumes the bank faces a downward sloping loan demand curve and is a price taker in securities markets uncertainty and liquidity requirements are incorporated bank decisions are made within a two stage framework where realized disturbances that violate constraints can be rectified ex post at a cost the results are 1 optimal loan and deposit rates are positive functions of the recourse penalty 2 asset liability decisions are interdependent and elastically supplied deposits lower the loan rate 3 the effect of uncertainty depends upon the penalty rate level

a corporate balance sheet approach to currency crises this paper presents a general equilibrium currency crisis model of the third generation in which the possibility of currency crises is driven by the interplay between private firms credit constraints and nominal price rigidities despite our emphasis on microfoundations the model remains sufficiently simple that the policy analysis can be conducted graphically the analysis hinges on four main features i ex post deviations from purchasing power parity ii credit constraints a la bernanke gertler iii foreign currency borrowing by domestic firms iv a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short term lending facilities we derive sufficient conditions for the existence of a sunspot equilibrium with currency crises we show that an interest rate increase intended to support the currency in a crisis may not be effective but that a relaxation of short term lending facilities can make this policy effective by attenuating the rise in interest rates relevant to firms

the changing international transmission of financial shocks evidence from a classical time varying favar we study the changing international transmission of financial shocks over the period 1971 2012 global financial shocks are measured as unexpected changes of a u s financial conditions index fci developed by hatzius et al 2010 we model the fci jointly with a large international data set through a time varying parameter factor augmented var and find that financial shocks have a considerable impact on growth in the nine countries considered moreover financial shocks during the global financial crisis are found to be large by historical standards they explain approximately 20 of gdp growth variation on average over 2008 9 compared to an average of 5 prior to the crisis

rational and self fulfilling balance of payments crises speculative attacks on a pegged exchange rate must sometimes occur ifasset price paths are to be free of abnormal profit opportunities suchattacks are fully rational as they reflect the market s response to aregime breakdown that is inevitable the authors shows that under someexpectations about policy balance of payments crises can also be purely self fulfilling events in such cases even a permanently viableregime may collapse and the economy will possess multiple equilibriacorresponding to different subjective assessments of the probability ofa crisis the behavior of the domestic interest rate will naturally reflect the possibility of a speculative attack copyright 1986 by american economic association

a simultaneous approach to the whether what and how much to buy questions consumer s purchase decisions of whether to buy what to buy and how much to buy are examined simultaneously based on a consumer utility maximization problem an unobservable threshold price about which a consumer pivots from nonpurchase to purchase can be deduced with any model specification the interrelationships between purchase decisions can be explicitly derived the model is applied to coffee purchasing data in addition by suppressing the nonpurchase options the model is compared with an alternative approach appearing in the marketing literature

fdi debt and capital controls abstract we examine the link between financial sector fdi flows banking debt flows and capital controls in emerging market economies during episodes of large gross capital inflows surges we find that fdi surges in the financial sector behave remarkably similar to surges in banking debt flows they are associated with boom bust cycles in gdp and expansions of credit in foreign currency unlike surges in fdi in the non financial sectors moreover global and contagion factors have a strong explanatory power in explaining surges in financial fdi and banking debt flows compared to surges in non financial sectors but capital controls have the opposite effect on the two types of flows restrictions on short term debt flows tend to decrease the likelihood of surges in banking debt flows but increase the likelihood of surges in financial sector fdi

managing interest rate risk in banking institutions abstract this paper develops and employs a multiperiod goal programming model to examine the normative effects of changing interest rates on the rearrangements of depository bank balance sheets and associated profits a two stage state preference framework allows a dynamic interpretation of the model s prescribed decisions as well as a natural incorporation of profit sensitivity to interest rate risk the model includes on and off the balance sheet decision variables experimental results indicate that constraining the latter decision can seriously curtail the bank s ability to achieve its profit objectives