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

asset prices and institutional investors empirical evidence indicates that trades by institutional investors have sizable effects on asset prices generating phenomena such as index effects asset class effects and others it is difficult to explain such phenomena within standard representative agent asset pricing models in this paper we consider an economy populated by institutional investors alongside standard retail investors institutions care about their performance relative to a certain index our framework is tractable admitting exact closed form expressions and produces the following analytical results we find that institutions optimally tilt their portfolios towards stocks that comprise their benchmark index the resulting price pressure boosts index stocks while leaving nonindex stocks unaffected by demanding a higher fraction of risky stocks than retail investors institutions amplify the index stock volatilities and aggregate stock market volatility and give rise to countercyclical sharpe ratios trades by institutions induce excess correlations among stocks that belong to their benchmark index generating an asset class effect institutions finance their additional purchases of index stocks by taking on leverage a policy prescription that calls for a reduction in leverage while reducing the riskiness of institutional portfolios would also reduce the ability of institutions to tilt their portfolios towards index stocks depressing the index level

beliefs about the determinants of success and employment protection abstract we show that part of the international variation in employment laws is due to different beliefs about the impact of hard work as opposed to luck and connections on success in societies where a greater proportion of people relate their life prospects to chance and connections stronger employment protection is in place the prevalence of such beliefs is likely to hamper labor market reforms

money interest rates and exchange rates with endogenously segmented markets we analyze the effects of money injections on interest rates and exchange rates when agents must pay a baumol tobin style fixed cost to exchange bonds and money asset markets are endogenously segmented because this fixed cost leads agents to trade bonds and money infrequently when the government injects money through an open market operation only those agents that are currently trading absorb these injections through their impact on these agents consumption these money injections affect real interest rates and real exchange rates the model generates the observed negative relation between expected inflation and real interest rates as well as persistent liquidity effects in interest rates and volatile and persistent exchange rates

aggregate implications of micro asset market segmentation an extensive empirical literature finds that micro asset markets are segmented from one another we develop a consumption based asset pricing model to quantify the aggregate implications of a financial system comprised of many such segmented micro asset markets we specify exogenously the level of segmentation that determines how much idiosyncratic risk traders bear in their micro market and calibrate the segmentation to match facts about systematic and idiosyncratic return volatility in our benchmark model traders bear 30 of their idiosyncratic risk the unconditional aggregate equity premium is 2 4 annual and the welfare costs of segmentation are substantial 1 8 of lifetime consumption

from cash in the market pricing to financial fragility we review some recent research that explores the relationship between asset price volatility and financial fragility when markets and contracts are incomplete jel e5 g2

belief disagreements and collateral constraints belief disagreements have been suggested as a major contributing factor to the recent subprime mortgage crisis this paper theoretically evaluates this hypothesis i assume that optimists have limited wealth and take on leverage so as to take positions in line with their beliefs to have a significant effect on asset prices they need to borrow from traders with pessimistic beliefs using loans collateralized by the asset itself since pessimists do not value the collateral as much as optimists do they are reluctant to lend which provides an endogenous constraint on optimists ability to borrow and to influence asset prices i demonstrate that the tightness of this constraint depends on the nature of belief disagreements optimism concerning the probability of downside states has no or little effect on asset prices because these types of optimism are disciplined by this constraint instead optimism concerning the relative probability of upside states could have significant effects on asset prices this asymmetric disciplining effect is robust to allowing for short selling because pessimists that borrow the asset face a similar endogenous constraint these results emphasize that what investors disagree about matters for asset prices to a greater extent than the level of disagreements when richer contracts are available relatively complex contracts that resemble some of the recent financial innovations in the mortgage market endogenously emerge to facilitate betting

the paradox of financial fire sales the role of arbitrage capital in determining liquidity how can fire sales for financial assets happen when the economy contains well capitalized but non specialist investors our explanation combines rational expectations equilibrium and lemons models when specialist informed market participants are liquidity constrained prices become less informative this creates an adverse selection problem decreasing the supply of high quality assets and lowering valuations by non specialist uninformed investors who become unwilling to supply capital to support the price in normal times arbitrage capital can multiply itself by making uninformed capital function as informed capital but in a crisis this stabilizing mechanism fails

the effect of green investment on corporate behavior this paper explores the effect of exclusionary ethical investing on corporate behavior in a risk averse equilibrium setting while arguments exist that ethical investing can influence a firm s cost of capital and so affect investment no equilibrium model has been presented to do so we show that exclusionary ethical investing leads to polluting firms being held by fewer investors since green investors eschew polluting firms stock this lack of risk sharing among non green investors leads to lower stock prices for polluting firms thus raising their cost of capital if the higher cost of capital more than overcomes a cost of reforming i e a polluting firm cleaning up its activities then polluting firms will become socially responsible because of exclusionary ethical investing a key determinant of the incentive for polluting firms to reform is the fraction of funds controlled by green investors in our model empirically reasonable parameter estimates indicate that more than 20 green investors are required to induce any polluting firmss to reform existing empirical evidence indicates that at most 10 of funds are invested by green investors

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

slow moving capital we study three cases in which specialized arbitrageurs lost significant amounts of capital and as a result became liquidity demanders rather than providers the effects on security markets were large and persistent prices dropped relative to fundamentals and the rebound took months while multi strategy hedge funds who were not capital constrained increased their positions a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm not just relative to outside investors can lead to capital constraints for trading desks with mark to market losses our findings suggest that real world frictions impede arbitrage capital this abstract was borrowed from another version of this item

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

pricing mortgage backed securities in a multifactor interest rate environment a multivariate density estimation approach multivariate density estimation mde suggests that mortgage backed security mbs prices can be well described as a function of the level and slope of the term structure we analyze bow this function varies across mbss with different coupons an important finding is that the interest rate level proxies for the moneyness of the option the expected level of prepayments and the average life of the cash flows while the term structure slope controls for the average rate at which these cash flows should be discounted though the origination and prepayment behavior of mortgages differ substantially across coupons there remains an unexplained common factor in mbs prices this factor does not seem to be related to the usual suspects and therefore presents a puzzle to financial economists coauthors are robert f whitelaw matthew richardson and richard stanton article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

information diversity and complementarities in trading and information acquisition we analyze a model in which different traders are informed of different fundamentals that affect the security value we identify a source for strategic complementarities in trading and information acquisition aggressive trading on information about one fundamental reduces uncertainty in trading on information about the other fundamental encouraging more trading and information acquisition on that fundamental this tends to amplify the effect of exogenous changes in the underlying information environment due to complementarities greater diversity of information in the economy improves price informativeness we discuss the relation between our model and recent financial phenomena and derive testable empirical implications

the real effects of sustainable responsible investing abstract sustainable and responsible investing sri may have a mixed effect on firms incentives to remove negative externalities whereas sri screening incentivizes the removal of externalities sri trading can disincentivize it when traders disagree on the externality removal s cash flow effects

a model of capital and crises we develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices the model is cast within a dynamic general equilibrium economy and the role for intermediation is derived endogenously based on optimal contracting considerations low intermediary capital reduces the risk bearing capacity of the marginal investor we show how this force helps to explain patterns during financial crises the model replicates the observed rise during crises in sharpe ratios conditional volatility correlation in price movements of assets held by the intermediary sector and fall in riskless interest rates

the environmental and macroeconomic effects of socially responsible investment abstract we analyze the effects of socially responsible investment and public abatement on environmental quality and the economy in a continuous time dynamic growth model featuring optimizing households and firms environmental quality is modeled as a renewable resource consumers can invest in government bonds or firm equity since investors feel partly responsible for environmental pollution when holding firm equity they require a premium on the return to equity we show that socially responsible investment behavior by households partially offsets the positive effects on environmental quality of public abatement policies

the deposits channel of monetary policy we propose and test a new channel for the transmission of monetary policy we show that when the fed funds rate increases banks widen the interest spreads they charge on deposits and deposits ow out of the banking system we present a model in which imperfect competition among banks gives rise to these relationships an increase in the nominal interest rate increases banks market power inducing them to increase deposit spreads and hence restrict deposit supply households respond to the increase in deposit prices by substituting from deposits into less liquid but higheryielding assets consequently changes in the nominal interest rate aect banks cost of capital and lending using branch level data on the universe of u s banks we show that following an increase in the fed funds rate deposit spreads increase by more and supply falls more in areas with less deposit competition we control for changes in banks lending opportunities by comparing branches of the same bank we control for changes in macroeconomic conditions by showing that deposit spreads widen immediately after a rate change and even if this change is fully anticipated our results imply that monetary policy has a signicant impact on how the nancial system is funded on the quantity of safe and liquid assets it produces and on its provision of loans to the real economy

capital mobility and asset pricing we present a model for the equilibrium movement of capital between asset markets that are distinguished only by the levels of capital invested in each investment in that market with the greatest amount of capital earns the lowest risk premium intermediaries optimally trade off the costs of intermediation against fees that depend on the gain they can offer to investors for moving their capital to the market with the higher mean return the bargaining power of an investor depends on potential access to alternative intermediaries in equilibrium the speeds of adjustment of mean returns and of capital between the two markets are increasing in the degree to which capital is imbalanced between the two markets and can be reduced by competition among intermediaries

leverage and beliefs personal experience and risk taking in margin lending what determines risk bearing capacity and the amount of leverage in financial markets using unique archival data on collateralized lending we show that personal experience can affect individual risk taking and aggregate leverage when an investor syndicate speculating in amsterdam in 1772 went bankrupt many lenders were exposed in the end none of them actually lost money nonetheless only those at risk of losing money changed their behavior markedly they lent with much higher haircuts the rest continued as before the differential change is remarkable since the distress was public knowledge overall leverage in the amsterdam stock market declined as a result

intermediary asset pricing abstract we model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary intermediaries face an equity capital constraint risk premia r

equilibrium analysis of portfolio insurance a martingale approach is used to characterize general equilibrium in the presence of portfolio insurance insurers sell to noninsurers in bad states and general equilibrium requires that the risk premium rises to induce noninsurers to increase their holdings we show that portfolio insurance increases price volatility causes mean reversion in asset returns raises the sharpe ratio and volatility in bad states and causes volatility to be correlated with volume we also explain why out of the money sp that is the demand for an absolute level of price protection is equivalent to a demand for put options 1 we show that a similar argument can be used in a

limits of arbitrage theory and evidence from the mortgage backed securities market limits of arbitrage theories hypothesize that the marginal investor in a particular asset market is a specialized arbitrageur rather than a diversified representative investor we examine the mortgage backed securities mbs market in this light we show that the risk of homeowner prepayment which is a wash in the aggregate is priced in the mbs market the covariance of prepayment risk with aggregate wealth implies the wrong sign to match the observed prices of prepayment risk the price of risk is better explained by a kernel based on mbs market wide specific risk consistent with the specialized arbitrageur hypothesis a number of recent limits of arbitrage theories predict that the distressed liquidation of assets by hedge funds results in a large drop in asset prices see for example shleifer and vishny 1997 kyle and xiong 2001 gromb and vayanos 2002 geanakoplos 2003 or he and krishnamurthy 2006 these theories are often referenced in explaining episodes of market illiquidity and falling asset prices such as the events during the fall of 1998 in traditional asset pricing theory the marginal investor in every asset market is the same broadly diversified representative investor thus a hedge fund liquidating 200 billion of mortgage backed securities finds a large pool of ready buyers comparable to the entire capital market and the liquidation does not affect expected returns because the representative investor acts quickly to eliminate excess returns according to the limits of arbitrage theory on the other hand the marginal investor in a particular asset market is an investor who specializes in that market in this case liquidations can have large effects on prices given that the relevant set of buyers is a smaller specialized pool of investors

presidential address asset price dynamics with slow moving capital i describe asset price dynamics caused by the slow movement of investment capital to trading opportunities the pattern of price responses to supply or demand shocks typically involves a sharp reaction to the shock and a subsequent and more extended reversal the amplitude of the immediate price impact and the pattern of the subsequent recovery can reflect institutional impediments to immediate trade such as search costs for trading counterparties or time to raise capital by intermediaries i discuss special impediments to capital formation during the recent financial crisis that caused asset price distortions which subsided afterward after presenting examples of price reactions to supply shocks in normal market settings i offer a simple illustrative model of price dynamics associated with slow moving capital due to the presence of inattentive investors i address the implications for asset price dynamics of the apparent slow movement of investment capital to trading opportunities the arrival of new capital to an investment opportunity can be delayed by fractions of a second in some markets for example an electronic limit order book market for equities or by months in other markets such as that for catastrophe risk insurance accordingly prices respond to supply or demand shocks with a sharp reaction because of the relatively small subset of capital and thus risk bearing capacity that is immediately available to absorb a shock on short notice such a price impact is substantially reversed over time as additional capital becomes available the amplitude of the immediate price impact and the pattern of the subsequent recovery can reflect many sorts of attention costs to trade as well as institutional impediments to capital movement such as search costs for trading

liquidity shortages and banking crises we show in this article that bank failures can be contagious unlike earlier work where contagion stems from depositor panics or contractual links between banks we argue that bank failures can shrink the common pool of liquidity creating or exacerbating aggregate liquidity shortages this could lead to a contagion of failures and a total meltdown of the system given the costs of a meltdown there is a possible role for government intervention unfortunately liquidity and solvency problems interact and can cause each other making it hard to determine the cause of a crisis we propose a robust sequence of intervention banks are often found at the center of systemic financial crises the causes of these crises have long been debated do they stem from depositor panics or do they arise because bank balance sheets are exposed to common factors if it is the latter then is there any sense in which bank failures can be contagious can anything be done to prevent these crises or stop them from propagating once they begin our purpose in this paper is to reexamine whether bank failures can start and propagate systemic crises even if we assume that depositors do not panic that is even if depositors actions are coordinated and they do not run simply because they fear others will run our focus is not because we think that panics are empirically unimportant the jury is still out on that instead we show that contagion can stem from an underlying real general equilibrium problem rather than just from lack of coordination among depositors from a policy perspective attempts to reassure investors through confidence building measures will not work if panic and lack of coordination are not the reasons for a crisis we begin in this paper with a model of a bank that we developed in diamond and rajan 2001 assets in this model are illiquid they cannot be borrowed against or sold for the full value of resources they will generate in their best use because the human capital necessary to generate that full value cannot

trading volume and serial correlation in stock returns this paper investigates the relationship between aggregate stock market trading volume and the serial correlation of daily stock returns for both stock indexes and individual large stocks the first order daily return autocorrelation tends to decline with volume the paper explains this phenomenon using a model in which risk averse market makers accommodate buying or selling pressure from liquidity or noninformational traders changing expected stock returns reward market makers for playing this role the model implies that a stock price decline on a high volume day is more likely than a stock price decline on a low volume day to be associated with an increase in the expected stock return