operating flexibility global manufacturing and the option value of a multinational network the multinational corporation is a network of activities located in different countries the value of this network derives from the opportunity to benefit from uncertainty through the coordination of subsidiaries which are geographically dispersed we model this coordination as the operating flexibility to shift production between two manufacturing plants located in different countries a stochastic dynamic programming model treats explicitly this flexibility as equivalent to owning an option the value of which is dependent upon the real exchange rate the model is extended to analyze hysteresis effects and within country growth options we show that the management of across border coordination has led to changes in the heuristic rules used for performance evaluation and transfer pricing

de gustibus non est taxandum heterogeneity in preferences and optimal redistribution abstract the prominent but unproven intuition that preference heterogeneity reduces redistribution in a standard optimal tax model is shown to hold under the plausible condition that the distribution of preferences for consumption relative to leisure rises in terms of first order stochastic dominance with income given familiar functional form assumptions on utility and the distributions of ability and preferences a simple statistic for the effect of preference heterogeneity on marginal tax rates is derived numerical simulations and suggestive empirical evidence demonstrate the link between this potentially measurable statistic and the quantitative implications of preference heterogeneity for policy

general equilibrium pricing of cpi derivatives we examine the issue of pricing forward futures and option contracts written on the consumer price index cpi the change of which is a measure of inflation affecting the economy traditional approaches postulate an exogenous process for the price level and then derive cpi derivatives prices by standard arbitrage arguments by contrast we build the general equilibrium of a continuous time monetary economy that is affected by both real and nominal shocks the price level and thus the inflation rate are found endogenously and solutions for the prices of cpi derivatives are obtained which are in closed form in a specialized version of the economy

robust stochastic discount factors when the market is incomplete a new non redundant derivative security cannot be priced by no arbitrage arguments alone moreover there will be a multiplicity of stochastic discount factors and each of them may give a different price for the new derivative security this paper develops an approach to the selection of a stochastic discount factor for pricing a new derivative security the approach is based on the idea that the price of a derivative security should not vary too much when the payoff of the primitive security is slightly perturbed i e the price of the derivative should be robust to model misspecification the paper develops two metrics of robustness the first is based on robustness in expectation the second is based on robustness in probability and draws on tools from the theory of large deviations we show that in a stochastic volatility model the two metrics yield analytically tractable bounds for the derivative price as the underlying stochastic volatility model is perturbed the bounds can be readily used for numerical examination of the sensitivity of the price of the derivative to model misspecification

popular acceptance of inequality due to innate brute luck and support for classical benefit based taxation abstract u s survey respondents views on distributive justice differ in two specific related ways from what is conventionally assumed in modern optimal tax research when expressing their preferences over allocations in stylized hypothetical scenarios meant to isolate key features of the tax problem a large share of respondents resist the full equalization of unequal outcomes due to innate brute luck that standard analyses recommend a similar share prefer a classical benefit based logic for taxes over the conventional logic of diminishing marginal social welfare moreover these two views are linked respondents who more strongly resist equalization are more likely to prefer the classical benefit based principle though the amazon mechanical turk survey population is not a representative sample of the u s population robustness of these results across demographic traits and political views suggests that a large share of the american public holds views inconsistent with standard welfarist objectives

interest rate volatility and the term structure a two factor general equilibrium model we develop a two factor general equilibrium model of the term structure the factors are the short term interest rate and the volatility of the short term interest rate we derive closed form expressions for discount bonds and study the properties of the term structure implied by the model the dependence of yields on volatility allows the model to capture many observed properties of the term structure we also derive closed form expressions for discount bond options we use hansen s generalized method of moments framework to test the cross sectional restrictions imposed by the model the tests support the two factor model there are essentially two approaches to the modeling of the term structure of interest rates in continuous time the equilibrium approach pioneered by

evaluating natural resource investments notwithstanding impressive advances in the theory of finance over the past 2 decades practical procedures for capital budgeting have evolved only slowly the standard technique which has remained unchanged in essentials since it was originally proposed see dean 1951 bierman and smidt 1960 derives from a simple adaptation of the fisher 1907 model of valuation under certainty under this technique expected cash flows from an investment project are discounted at a rate deemed appropriate to their risk and the resulting present value is compared with the cost of the project this standard textbook technique reflects modern theoretical developments only insofar as estimates of the discount rate may be obtained from crude application of single period asset pricing theory but see brennan 1973 bogue and roll 1974 turnbull 1977 constantinides 1978 the inadequacy of this approach to capital budgeting is widely acknowledged although not widely discussed its obvious deficiency is its the evaluation of mining and other natural resource projects is made particularly difficult by the high degree of uncertainty attaching to output prices it is shown that the techniques of continuous time arbitrage and stochastic control theory may be used not only to value such projects but also to determine the optimal policies for developing managing and abandoning them the approach may be adapted to a wide variety of contexts outside the natural resource sector where uncertainty about future project revenues is a paramount concern

the volatility risk premium embedded in currency options this study employs a non parametric approach to investigate the volatility risk premium in the over the counter currency option market using a large database of daily delta neutral straddle quotes in four major currencies the british pound the euro the japanese yen and the swiss franc we find that volatility risk is priced in all four currencies across different option maturities we find that the volatility risk premium is negative with the premium decreasing in maturity finally we also find evidence that jump risk may be priced in the currency option market

logarithmic preferences myopic decisions and incomplete information this paper examines a dynamic production economy with incomplete information and shows that the set of myopic preferenees those that induee myopic decisions depends on the representation of the information flow for example logarithmic preferenees are nonmyopic when some of the economic state variables are unobservable the analysis offers a broader definition of myopic behavior termed generalized myopia which is independent of the representation of the information flow allowing for any smooth concave utility function logarithmic preferenees endogenously emerge as necessary for generalized myopia in incomplete information economies and when combined with restrictions on the information structure they become sufficient i introduction this paper investigates myopic decisions and myopic preferenees in an in complete information production economy with continuous consumption and in vestment the paper interprets myopic decisions as those that do not use informa tion regarding future investment opportunities and identifies specific conditions for myopia within the model although previous research in financial economics has associated logarithmic preferenees with myopic behavior this analysis demonstrates that logarithmic preferenees necessarily induee myopic behavior only when all the economic state variables are observable based on this analysis the paper proposes a broader definition of myopia termed generalized myopia that is independent of the information flow representation the paper also provides nec essary and sufficient conditions for the existence of generalized myopia within both complete and incomplete information economies while the analysis allows for any smooth concave utility function logarithmic preferenees endogenously arise as necessary for generalized myopia in incomplete information economies and when combined with restrictions on the information structure they become sufficient

using elasticities to derive optimal income tax rates this paper derives optimal income tax formulas using compensated and uncompensated elasticities of earnings with respect to tax rates a simple formula for the high income optimal tax rate is obtained as a function of these elasticities and the thickness of the top tail of the income distribution in the general non linear income tax problem this method using elasticities shows precisely how the different economic effects come into play and which are the key relevant parameters in the optimal income tax formulas of mirrlees the optimal non linear tax rate formulas are expressed in terms of elasticities and the shape of the income distribution these formulas are implemented numerically using empirical earning distributions and a range of realistic elasticity parameters

on arbitrage free pricing of interest rate contingent claims unlike most interest rate claim models the ho lee model utilizes full information on the current term structure unfortunately the model has a major deficiency in that negative interest rates can occur this article modifies the model such that interest rates are well behaved

revisiting the classical view of benefit based taxation this paper explores how the persistently popular classical logic of bene t based taxation in which an individual s bene t from public goods is tied to his or her income earning ability can be incorporated into modern optimal tax theory if lindahl s methods are applied to that view of bene ts rst best optimal policy can be characterized analytically as depending on a few potentially estimable statistics in particular the coe cient of complementarity between public goods and innate talent constrained optimal policy with a pareto e cient objective that strikes a balance controlled by a single parameter between this principle and the familiar utilitarian criterion can be simulated using conventional constraints and methods a wide range of optimal policy outcomes can result including those that match well several features of existing policies to the extent that such an objective re ects the mixed normative reasoning behind prevailing

theoretical relations between risk premiums and conditional variances many statistical models of time varying risk premiums including the autoregressive conditional heteroscedasticity arch in mean attempt to exploit a relation between risk premiums and conditional variances or covariances of asset returns we examine this relation in numerical versions of a dynamic asset pricing theory and show that it can be increasing decreasing flat or nonmonotonic its shape depends on both the preferences of the representative agent and the stochastic structure of the economy without additional structure the theory does not provide either a general foundation for arch in mean specifications or a simple interpretation of their parameters

a dynamic programming approach for pricing options embedded in bonds abstract we propose a dynamic programming dp approach for pricing options embedded in bonds the focus being on call and put options with advance notice an efficient procedure is developed for the cases where the interest rate process follows the vasicek cox ingersoll ross cir or generalized vasicek models our dp methodology uses the exact joint distribution of the interest rate and integrated interest rate at a future date conditional on the current value of the interest rate we provide numerical illustrations for the vasicek and cir models comparing our dp method with finite difference methods our procedure compares quite favorably in terms of both efficiency and accuracy an important advantage of the our dp approach is that it can be applied to more general models calibrated to capture the term structure of interest rates e g the generalized vasicek model

valuing managerial flexibility an application of real option theory to mining investments abstract the value of managerial flexibility is assessed using data on prices costs grades reserves ore extraction and metal output for a panel of canadian copper mines a real option model is estimated and solved for project and option values most empirical researchers i consider the initial investment decision but neglect flexible operation thereafter ii assume that price is stochastic but ignore cost and reserve uncertainty and iii model price as a nonstationary stochastic process the evolution of three state variables price cost and reserves is assessed here differences in assumptions compared to others are found to lead to large differences in estimated project and option values

pricing claims under garch level dependent interest rate processes this article considers the pricing of interest rate sensitive claims when the underlying interest rate is driven by a two state variable garch process analytical solutions are established for the case when the innovations in the short rate are normal and or chi squared random variables and the volatility of rates take on a special garch form garch models that nest level dependent interest rate models including the cox ingersoll and ross model are also considered algorithms are provided that permit the efficient pricing of american style interest rate claims under a rather broad array of garch level dependent processes

the pension costs from a defined benefit to individual pension accounts do they cost more in the case of taiwan this article develops a market based liability valuation model to price individual pension costs of a defined benefit db pension plan the purpose is to compare them with the new labour pension plan individual pension accounts ipas in the case of taiwan the results based on the numerical approach show that the new ipas cost a company more than the old db plan except if the average wage growth relative to the risk free interest rate is high enough

parameter estimation in stochastic scenario generation systems abstract scenario analysis offers an effective tool for addressing the stochastic elements in multi period financial planning models critical to any scenario generation process is the estimation of the input parameters of the underlying stochastic model for economic factors in this paper we propose a new approach for estimation known as the integrated parameter estimation ipe this approach combines the significant features of other well known estimation techniques within a non convex multiple objective optimization framework with the objective weights controlling the relative importance of the features we solve the non convex optimization problem using adaptive memory programming a variation of tabu search based on a short interest rate model using uk treasury rates from 1980 to 1995 the integrated approach compares favorably with maximum likelihood and the generalized method of moments we also evaluate performance with towers perrin s cap link scenario generation system

the funding for a defined benefit db pension plan based on the fair valuation of the plan s insolvency risk this study provides a contingent claims valuation approach model to value a sponsor s claim on a salary related defined benefit db pension plan the model is further developed to numerically estimate a suggested optimal contribution cost that allows the sponsor to fairly bear the risk of the plan s insolvency the results demonstrate that the traditional actuarial valuation underestimates the cost of pension benefits and that the normal contribution cost is not enough for the sponsor to fairly charge the value of bearing the plan s insolvency

hysteresis effects under cir interest rates most decision making research in real options focuses on revenue uncertainty assuming discount rates remain constant however for many decisions revenue or cost streams are relatively static and investment is driven by interest rate uncertainty for example the decision to invest in durable machinery and equipment using interest rate models from cox et al 1985b we generalize the work of ingersoll and ross 1992 in two ways firstly we include real options on perpetuities in addition to zero coupon cash flows secondly we incorporate abandonment or disinvestment as well as investment options and thus model interest rate hysteresis parallel to revenue uncertainty in dixit 1989a under stochastic interest rates economic hysteresis is found to be significant even for small sunk costs

smooth pasting as rate of return equalization abstract we further elucidate the smooth pasting condition behind optimal early exercise of options it is easy to show that smooth pasting implies rate of return equalization between the option and the levered position that results from exercise this yields new economic insights into the optimal early exercise condition that the option holder faces

the effect of transaction size on off the run treasury prices this paper examines intra day trading data from the inter dealer broker market for u s treasury securities and measures the degree of price pressure in the off the run treasury market as is well known securities that would appear to be very close substitutes i e on the run and off the run treasury bonds behave as if there is some degree of market segmentation this is the first systematic study of the off the run treasury note and bond market focused entirely on a price pressure effect using intra day data the paper analyzes price pressure through matched pairs of securities that differ only in liquidity

the valuation of multiple claim insurance contracts this paper provides a closed form solution for the value of a multiple claim insurance contract that is subject to a deductible amount and or an upper limit on claims the solution is a time integral of european option prices the model provides three important insights first systematic risk in insurance policies is altered in the presence of deductibles and maximum indemnity levels second idiosyncratic risk affects policy valuation and the required rates of return on underwriting portfolios finally contrary to traditional actuarial intuition changes in the risk free interest rate may either increase or reduce policy values

exact solutions for futures and european futures options on pure discount bonds this paper provides closed form solutions for futures and european futures options on pure discount bonds under the ornstein uhlenbeck normal process a significant difference between black s model 1976 and the model in this paper for futures options is discussed

a nonlinear general equilibrium model of the term structure of interest rates abstract we derive and test an alternative closed form general equilibrium model of the term structure within the cox ingersoll and ross theoretical framework in which yields are nonlinear functions of the risk free rate we show that equilibrium bond prices and the risk free rate are not always inversely related and that bond risk need not be strictly increasing in maturity using hansen s generalized method of moments to obtain parameter estimates this nonlinear model outperforms the cox ingersoll and ross square root model in describing actual treasury bill yields for the 1964 1986 period

continuous time methods in finance a review and an assessment i survey and assess the development of continuous time methods in finance during the last 30 years the subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing term structure theory asset pricing and optimal consumption and portfolio choices during the period 1981 to 1999 the theory has been extended and modified to better explain empirical regularities in various subfields of finance this latter subperiod has seen significant progress in econometric theory computational and estimation methods to test and implement continuous time models capital market frictions and bargaining issues are being increasingly incorporated in continuous time theory the roots of modern continuous time methods in finance can be traced back to the seminal contributions of merton 1969 1971 1973b in the late 1960s and early 1970s merton 1969 pioneered the use of continuous time modeling in financial economics by formulating the intertemporal consumption and portfolio choice problem of an investor in a stochastic dynamic programming setting merton 1973b also showed how such a framework can be used to develop equilibrium asset pricing implications thereby significantly extending the asset pricing theory to richer dynamic settings and expanding the scope of applications of continuous time methods to study problems in financial economics 1 within a span of about 30 years from the publication of merton s inf luential papers continuous time methods have become an integral part of financial economics indeed in certain core areas in finance such as e g asset pricing derivatives valuation term structure theory and portfolio selection continuoustime methods have proved to be the most attractive way to conduct research and gain economic intuition the continuous time approach in these areas has produced models with a rich variety of testable implications the econometric theory for testing continuous time models has made rapid strides in the last decade and has thus kept pace with the impressive progress on the theoretical front one hopes that the actual empirical investigations and estimation using the new procedures will follow suit soon

an intertemporal general equilibrium model of asset prices this paper develops a continuous time general equilibrium model of a simple but complete economy and uses it to examine the behavior of asset prices in this model asset prices and their stochastic properties are determined endogenously one principal result is a partial differential equation which asset prices must satisfy the solution of this equation gives the equilibrium price of any asset in terms of the underlying real variables in the economy in this paper we develop a general equilibrium asset pricing model for use in applied research an important feature of the model is its integration of real and financial markets among other things the model endogenously determines the stochastic process followed by the equilibrium price of any financial asset and shows how this process depends on the underlying real variables the model is fully consistent with rational expectations and maximizing behavior on the part of all agents our framework is general enough to include many of the fundamental forces affecting asset markets yet it is tractable enough to be specialized easily to produce specific testable results furthermore the model can be extended in a number of straightforward ways consequently it is well suited to a wide variety of applications for example in a companion paper cox ingersoll and ross 7 we use the model to develop a theory of the term structure of interest rates many studies have been concerned with various aspects of asset pricing under uncertainty the most relevant to our work are the important papers on intertemporal asset pricing by merton 19 and lucas 16 working in a continuous time framework merton derives a relationship among the equilibrium expected rates of return on assets he shows that when investment opportunities are changing randomly over time this relationship will include effects which have no analogue in a static one period model lucas considers an economy with homogeneous individuals and a single consumption good which is produced by a number of processes the random output of these processes is exogenously determined and perishable assets are defined as claims to all or a part of the output of a process and the equilibrium determines the asset prices our theory draws on some elements of both of these papers like merton we formulate our model in continuous time and make full use of the analytical tractability that this affords the economic structure of our model is somewhat similar to that of lucas however we include both endogenous production and

interest rate parity and the exchange risk premium evidence from panel data abstract this paper provides evidence that a time varying risk premium is responsible for the rejection of the interest rate parity theory we use a panel data set of returns on eurocurrency deposits and employ cross section time series methods to account for common movements in risk premia across deposits denominated in different currencies

valuation and analysis of collateralized mortgage obligations this study develops a model for the valuation of collateralized mortgage obligations cmos the model is based on a two factor model of the term structure of interest rates and embeds an empirically estimated mortgage prepayment function the model is used to analyze various cmo tranches including standard sequential pay fixed rate tranches planned amortization class pac tranches targeted amortization class tac tranches floating rate tranches interest only io and principal only po tranches z bonds and residuals the results of this analysis illustrate the sensitivity of the various tranches to differences in cmo structure changes in interest rates the characteristics of the underlying collateral and mortgage prepayments

the pricing of stock index options in a general equilibrium model this paper analyzes the pricing of stock index options in a simple general equilibrium model in this model the volatility of the stock index and the spot rate of interest are functions of a stochastic variable the paper investigates the biases that arise when using the black scholes model with the assumed volatility and interest rate dynamics it is shown that the model can in principle explain the biases observed in empirical work on stock index options

stochastic equilibrium discounting abstract this paper considers the determination of equilibrium asset prices in an infinite horizon diffusion model of an exchange economy it is shown that asset prices can be expressed as properly weighted sums of asset payouts equilibrium properties are also investigated under the assumption that the state of the economy follows its invariant distribution

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

the value of tax progressivity evidence from survey experiments abstract the aim of this paper is to investigate how people value tax progressivity more precisely i study the potential trade off between any improvement in the final income distribution and the progressivity of the tax schedule to do this i designed survey experiments in which respondents were asked to rank or to choose between different taxation redistribution schemes with different treatments varying in terms of information availability 1 when only information about final incomes is provided and 2 when information about average tax rates is also available using a within subject design the instability of rankings between 1 and 2 indicates whether or not respondents value tax progressivity i find that information about tax rates significantly affects respondents judgments about tax schemes they exhibit a strong preference for tax progressivity i e they accept a fall in the quality of the final income distribution in exchange for progressive taxation the results of an additional treatment suggest that the mere fact of providing new information cannot account for this finding

a continuous time equilibrium model of forward prices and futures prices in a multigood economy abstract this paper is a theoretical investigation of equilibrium forward and futures prices we construct a rational expectations model in continuous time of a multigood identical consumer economy with constant stochastic returns to scale production using this model we find three main results first we find formulas for equilibrium forward futures discount bond commodity bond and commodity option prices second we show that a futures price is actually a forward price for the delivery of a random number of units of a good the random number is the return earned from continuous reinvestment in instantaneously riskless bonds until maturity of the futures contract third we find and interpret conditions under which normal backwardation or contango is found in forward or futures prices these conditions reflect the usefulness of forward and futures contracts as consumption hedges

simple binomial processes as diffusion approximations in financial models a binomial approximation to a diffusion is defined as computationally simple if the number of nodes grows at most linearly in the number of time intervals it is shown how to construct computationally simple binomial processes that converge weakly to commonly employed diffusions in financial models the convergence of the sequence of bond and european option prices from these processes to the corresponding values in the diffusion limit is also demonstrated numerical examples from the constant elasticity of variance stock price and the cox ingersoll and ross 1985 discount bond price are provided article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

how elastic are preferences for redistribution evidence from randomized survey experiments we analyze randomized online survey experiments providing interactive customized information on us income inequality the link between top income tax rates and economic growth and the estate tax the treatment has large effects on views about inequality but only slightly moves tax and transfer policy preferences an exception is the estate tax informing respondents of the small share of decedents who pay it doubles support for it the small effects for all other policies can be partially explained by respondents low trust in government and a disconnect between concerns about social issues and the public policies meant to address them jel d31 d72 h23 h24

on real interest rate dynamics and regime switching abstract we find evidence of regime switching dynamics in the usa and the uk real interest rates over the period 1881 2003 for the uk there is a regime in which the real interest rate displays a relatively stronger mean reversion and a regime in which it displays a relatively weaker mean reversion the former regime is characterized by a relatively larger error in the estimation of the reversion parameter and higher volatility for the usa the two regimes differ in volatility the probability of transition from one regime to another is found to be significantly related to the inflation rate regime and to the political regime the results highlight the importance of regime switching in the dynamics of the real interest rate as well as the role of inflation and political regimes in explaining this switching

the term structure of interest rates with housing abstract this paper develops a general equilibrium model to study the link between the amount of capital invested in housing assets and the term structure of interest rates in the model the production of housing assets is irreversible and housing assets can be used as collateral for borrowing funds agents decisions about consumption and investments in housing and non housing assets generate a time varying market price of risk that drives the dynamics of the term structure the calibration to u s data using the simulated method of moments technique captures the dynamics of consumption and the short and long term interest rates

an equilibrium model of exchange rate determination and asset pricing with nontraded goods and imperfect information this paper presents a two country model with maximizing households stochastic production stochastic money growth and perfect capital mobility because of the presence of nontraded goods households in different countries consume different goods analytic solutions are presented for the nominal exchange rate the real exchange rate nominal interest rates and real interest rates it is shown that the model is compatible with some important features of the real world behavior of exchange rates when households are imperfectly informed about the distribution of money growth the exchange rate exhibits patterns of overshooting and is more volatile than the ratio of the money stocks copyright 1987 by university of chicago press

the information content in bond model residuals an empirical study on the belgian bond market abstract we estimate daily vasicek cir and spline models on belgian data and compare the trading profits that can be made on the basis of their residuals abnormal returns measured using three different benchmarks are negatively related to once and twice lagged mispricing buying underpriced bonds and especially selling overpriced bonds yields significant abnormal returns even when the trade is delayed by up to five days after observing the mispricing the traditional spline model overfits the data and is least able to detect mispricing large model residuals are more likely to be the result of model misspecification or estimation than are small or medium sized residuals

fair income tax fairness is a key concept in redistribution issues in this paper we study how particular requirements of fairness can shed light on the design of the optimal income tax schedule we consider a population of heterogeneous individuals or households who differ in two respects first they have unequal skills and therefore unequal earning abilities second they differ in terms of their preferences about consumption and leisure and as a consequence typically make different labour time choices both kinds of differences generate income inequalities we study how to justify and compute a redistribution income tax in this context redistribution through an income tax usually entails distortions of incentives but the resulting efficiency loss has to be weighed against potential improvements in the fairness of the distribution of resources we address this efficiency equity trade off here by constructing social preferences which obey the standard pareto principle in addition to fairness conditions

the risk premium of volatility implicit in currency options this article provides an empirical investigation of the risk neutral variance process and the market price of variance risk implied in the foreign currency options market there are three principal contributions first the parameters of heston s mean reverting square root stochastic volatility model are estimated using dollar mark option prices from 1987 to 1992 second it is shown that these implied parameters can be combined with historical moments of the dollar mark exchange rate to deduce an estimate of the market price of variance risk these estimates are found to be nonzero time varying and of sufficient magnitude to imply that the compensation for variance risk is a significant component of the risk premia in the currency market finally the out of sample test suggests that the historical variance and the hull and white implied variance contain no more information than that imbedded in the heston implied variance

hedging in the possible presence of unspanned stochastic volatility evidence from swaption markets this paper examines whether higher order multifactor models with state variables linked solely to underlying libor swap rates are by themselves capable of explaining and hedging interest rate derivatives or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary our research shows that swaptions and even swaption straddles can be well hedged with libor bonds alone we examine the potential benefits of looking outside the libor market for factors that might impact swaption prices without impacting swap rates and find them to be minor indicating that the swaption market is well integrated with the libor swap market

securities markets diffusion state processes and arbitrage free shadow prices this paper develops the parametric restrictions imposed on diffusion state processes by the requirement of arbitrage free asset pricing using the equivalent martingale measure as a starting point the diffusion property is exploited to specify the shadow pricing func tion which takes conditional state variable probabilities under the reference measure into arbitrage free contingent claim prices the main results of the paper provide differential equations associated with the shadow price function that are used to identify restrictions on the parameters of assumed diffusion processes the paper concludes with an application to the cir model where the state variable the instantaneous interest rate is assumed to follow a square root process calculations are also provided for the parametric restrictions imposed on the brownian bridge and ou state variable processes

time horizon and the discount rate abstract we consider an economy a la lucas 1978 econometrica46 1429 1446 with a risk averse representative agent the exogenous growth rate of the economy follows a random walk we characterize the set of utility functions for which it is efficient to discount more distant cash flows at a lower rate the benchmark result is that when the growth rate is almost surely nonnegative the yield curve is decreasing if and only if relative risk aversion is decreasing with wealth relaxing the assumption on the absence of recession requires more restrictions on preferences such as increasing relative prudence journal of economic literature classification numbers d81 d91 q25 q28

notes on multiperiod valuation and the pricing of options a comment rates as somehow deeper and more significant than those that serve other purposes whereas the two types of models differ mainly in terms of the variables assumed to be endogenous or exogenous bhattacharya believes that the assumptions of the ss model exponential utility multivariate normally distributed cash flows and non stochastic future interest rates are mutually inconsistent he also does not realize that unlike most of the models he surveys the ss model is fully consistent with the single period mean variance capital asset pricing model capm i e has rationally expected normal distributions of future stock prices another major advantage of the ss model is that it states firm values as functions of inter and intratemporal covariances of cash flows analogous to the single period capm while maintaining the essential features of the multiperiod valuation problem given these lacunae in the bhattacharya survey we can only conclude that the relationship between different multiperiod models requires further clarification we first deal with the substantive point about the consistency of the ss assumptions and then comment on the linkages between the assumptions and results of various multiperiod models

equilibrium valuation of foreign exchange claims this article studies the equilibrium valuation of foreign exchange contingent claims within a continuous time lucas 1982 two country model exchange rates interest rates and in particular factor risk prices are all endogenously and jointly determined this guarantees the internal consistency of these price processes with a general equilibrium in the same model closed form valuation formulas are presented for currency options and currency futures options common to these formulas is that stochastic volatility and stochastic interest rates are admitted hedge ratios and other comparative statics are also provided analytically it is shown that most existing currency option models are included as special cases this article studies the equilibrium valuation and hedging of foreign exchange contingent claims the framework for analysis is the continuous time counterpart of the well known two country monetary model of lucas 1982 1 that is we use the modeling structure of lucas 1982 and adopt his representativeagent perfect pooling equilibrium notion rather than extending the lucas setup to a cox ingersoll and ross 1985a henceforth cir production economy as is done in nielsen and saa requejo 1993 for our purpose the lucas framework offers the desired simplicity and tractability we assume a stochastic structure for the international economy such that the resulting nominal interest rates and exchange rate dynamics exhibit similar empirically plausible features as the corresponding ones in nielsen and saa requejo 1993 for example the endogenous interest rates are positively correlated across national borders campbell and clarida 1987 and ilmanen 1995 as a predictor of future spot exchange rates the equilibrium forward exchange rate is biased in a direction consistent with the forward premium puzzle

corporate compliance with debt covenants in this paper i present and test a model of corporate compliance with the debt covenant requiring payment of a current obligation this study adds to the empirical literature on forecasting financial distress by showing conditions under which debt default may be a rational economic decision by the firm s shareholders this analysis departs from empirical financial distress studies which are often not linked to an underlying economic theory the focus on covenant default also extends the literature which has modeled bankruptcy bulow and shoven 1978 and liquidation decisions titman 1984 but which has not considered a common first symptom of financial distress covenant default briefly the model examines the costs that influence shareholders decision to comply with or violate a particular debt covenant payment of a current obligation these costs include those associated with bondholders reaction to possible default the model predicts that shareholders will default when holding other factors constant i interest rates have declined relative to coupon rates stated in the debt issue ii the probability of paying future obligations is high and iii the cost of obtaining funds to pay the obligation is high the model also predicts when stockholders and bondholders will renegotiate the debt contract and the amount of wealth transferred in the renegotiation finally the

a simple nonnegative process for equilibrium models abstract this paper presents a general specification for dynamic equilibrium models where nonnegative variables follow the autoregressive gamma process in jasiak and gourieroux 2006 the model solution implies linear dynamics for endogenous variables and provides conditional and unconditional moments in closed form finding the solution is computationally inexpensive requiring only to solve linear and quadratic equations the specification can be applied to a wide variety of models in finance and economics two applications are presented first a time varying volatility premium in a long run risks asset pricing model second time varying volatility in policy shocks in a simple new keynesian model accuracy in these models solutions is high and not significantly affected by time varying volatility

pricing weather derivatives this article presents a general method for pricing weather derivatives specification tests find that a temperature series for fresno ca follows a mean reverting brownian motion process with discrete jumps and autoregressive conditional heteroscedastic errors based on this process we define an equilibrium pricing model for cooling degree day weather options comparing option prices estimated with three methods a traditional burn rate approach a black scholes merton approximation and an equilibrium monte carlo simulation reveals significant differences equilibrium prices are preferred on theoretical grounds so are used to demonstrate the usefulness of weather derivatives as risk management tools for california specialty crop growers

accounting for forward rates in markets for foreign currency absteract forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure the intertemporal marginal rate of substitution representative agent theory with time additive preferences cannot account for either of these properties we show that the theory does considerably better along these dimensions when the representative agent s preferences exhibit habit persistence but that the theory fails to reproduce some of the other properties of the data in particular the strong autocorrelation of forward premiums since the advent of flexible exchange rates in the early 1970s a large body of statistical work has established that forward rates for major currencies are not optimal predictors of future spot rates relevant evidence is reported in studies by baillie lippens and mcmahon 1983 bekaert 1991 bilson 1981 boothe and longworth 1984 cumby 1988 cumby and obstfeld 1984 fama 1984 gregory and mccurdy 1984 hansen and hodrick 1983 hodrick and srivastava 1984 and korajczyk and viallet 1990 a more complete list of references is provided by hodrick 1987 these papers indicate that returns from speculation in forward and spot currency markets are predictable and that the predictable components vary considerably over time a number of alternative explanations have been offered for the predictable variation in foreign currency market excess returns kaminsky 1988 korajczyk 1985 and krasker 1980 suggest that infrequent extreme events may make returns appear predictable in small samples the so called peso problem lewis 1989 argues that rational learning following infrequent changes in the process governing equilibrium prices can explain part of the ex post predictability of currency returns froot and frankel 1989 and froot and thaler 1990 examine the hypothesis that market forecasts of future spot

irreversible investment under interest rate variability some generalizations we study the impact of interest rate and revenue variability on the decision to carry out irreversible investment we provide a mathematical characterization of the two dimensional optimal stopping problem and show that interest rate variability has a decelerating or accelerating impact on investment depending on whether the current interest rate is below or above the long run steady state allowing for interest rate volatility decelerates investment by raising both the required exercise premium of the investment opportunity and the value of waiting finally increased revenue volatility is shown to strengthen the negative impact of interest rate volatility and vice versa

option value uncertainty and the investment decision the options based approach to studying irreversible investment under uncertainty emphasizes that the opportunity cost of investment includes the value of the option to wait that is extinguished when an investment is undertaken thus the investment decision is affected by the determinants of the value of this option we extend and generalize a standard model of irreversible investment by introducing a second fully reversible technology and also incorporate partial reversibility by allowing capital to be abandoned at a cost as in the existing literature we find that the threshold value of the underlying asset in our case demand at which investment takes place is increasing in the uncertainty of demand we also find that the value of the option and thus the threshold value of the option value multiple at which investment takes place may be either increasing or decreasing in the uncertainty of demand in addition we find that for the case in which capital is used to replace the reversible technology the threshold value of the option value multiple is insensitive to the degree of reversibility of capital

the valuation of forestry resources under stochastic prices and inventories a contingent claims approach to capital budgeting may be preferable to traditional methods where uncertainty and managers strategic reactions to changing conditions are impor tant as an example of such a case we solve the classical problem of the duration of an investment in forestry resources i e when to cut down the trees in the general case of stochastic output prices and stochastic natural growth rate and timber inventories a con tingent claims approach is used to value the forestry resources as a function of 1 sto chastic prices and inventories and 2 an asymmetric optimal production policy that incorporates the option to halt timber production temporarily i introduction classical capital budgeting techniques are based on the assumption that fu ture cash flows follow a rigid pattern and can be accurately predicted far into the future on the basis of such cash flow predictions the project is either accepted or rejected the uncertainty in the project and management s strategic reactions to changing conditions are dealt with only superficially at best a risk adjusted interest rate is employed and various deterministic scenarios are plotted out in situations where uncertainty and management s strategic reactions to it are im portant the classical technique is apt to lead to wrong decisions the technology needed to deal with such problems more accurately is becoming available the purpose of this paper is to present a stylized example of how it can be used our example is a general solution to the classical duration problem of the optimal control of a long term renewable resource investment such as forestry resources i e when to chop down a tree 1 if the prices and the natural growth rate of the inventory of forest timber are assumed to be deterministic the optimal control is very simple to derive but when both the price and inventory of timber are stochastic the problem becomes both stochastic and asymmetric the asym

nominal contracts in a bimetallic standard as its central feature a bimetallic standard grants nominal debtors an option to deliver either of two metals with results from the option pricing literature construction of a formula to evaluate the bimetallic option in debt instruments is straightforward with this formula one can compute the option value in a wide range of nineteenth century u s treasury securities posession of the option values permits an adjustment of the yields on u s securities to make them comparable to yields on nonmetallic european securities evaluating the option allows the estimation of transfers from debtors to creditors copyright 1986 by american economic association

an intertemporal general equilibrium asset pricing model the case of diffusion information this paper provides sufficient conditions for the equilibrium price system and a vector of exogenously specified state variable processes to form a diffusion process in a pure exchange economy the conditions involve smoothness of agents utility functions and certain nice properties of the aggregate endowment process and the dividend processes of traded assets in place of the dynamic programming a martingale representation technique is utilized to characterize equilibrium portfolio policies this technique is useful even when there does not exist a finite dimensional markov structure in the economy and thus the markovian stochastic dynamic programming is not applicable a gents are shown to hold certain hedging mutual funds and the riskless asset in contrast to earlier results the market portfolio does not have a special role in hedging since the markets are dynamically complete when there exists a finite dimensional markov system in the economy the dimension of the hedging demand identified through the markovian dynamic programming may be much larger than that identified by the martingale method copyright 1987 by the econometric society

the promise of positive optimal taxation normative diversity and a role for equal sacrifice abstract a prominent assumption in modern optimal tax research is that the objective of taxation is utilitarian i present new survey evidence that most people reject this assumption s implications for several prominent features of tax policy instead preferring tax policies based at least in part on a classic alternative objective the principle of equal sacrifice i generalize the standard model to accommodate this preference for a mixed objective proposing a method by which to make disparate criteria commensurable while respecting pareto efficiency then i show that optimal policy in this generalized model calibrated to the survey evidence and u s microdata is capable of quantitatively matching several features of existing tax policy that are incompatible in the conventional model but widely endorsed in the survey and reality including the coexistence of substantial redistribution and limited tagging together these findings demonstrate the potential of a positive theory of optimal taxation

shifting endpoints in the term structure of interest rates abstract this paper links the term structure to perceptions of monetary policy long horizon forecasts of short rates required by no arbitrage term structure models are heavily influenced by the endpoints or limiting conditional forecasts of the short rate process common assumptions that the short rate is mean reverting or contains a unit root are shown to generate unrealistic yield predictions failures occur because these assumptions inadequately account for historical shifts in market perceptions of the policy target for inflation this paper links endpoint shifts to agent learning about shifts in long term policy goals shifting endpoints in short rate processes significantly improve yield predictions

dynamic asset pricing with non redundant forwards abstract in an incomplete market in which non redundant forward contracts contribute to span the uncertainty some standard results of portfolio theory must be amended when the investment opportunity set is driven by k state variables a k 3 mutual fund separation theorem is obtained in lieu of merton s k 2 fund separation result the additional fund is a portfolio that hedges the interest rate risk brought about by the optimal portfolio strategy itself second the mean variance efficiency of the market portfolio of cash assets is neither a necessary nor a sufficient condition for the linear relationship between expected return and beta to hold third the pricing equation for a forward contract is shown to contain an extra term relative to that for a cash asset term we name strategy risk premium

single factor heath jarrow morton term structure models based on markov spot interest rate dynamics this paper considers the class of heath jarrow morton term structure models where the spot interest rate is markov and the term structure at time t is a function of time maturity and the spot interest rate at time t a representation for this class of models is derived and i show that the functional forms of the forward rate volatility structure and the initial forward rate curve cannot be arbitrarily chosen i provide necessary and sufficient conditions indicating which combinations of these functional forms are allowable i also derive a partial differential equation representation of the term structure dynamics that does not require explicit modeling of both the market price of risk and the drift term for the spot interest rate process using the analysis presented in this paper a class of intertemporal term structure models is derived

waiting to invest investment and uncertainty the textbook analysis that accepts all projections with positive net present values as positive is quite generally wrong the ability to delay a project means that almost every project competes with itself postponed with uncertain interest rates even the simplest of projects has an option value the effect of interest rate uncertainty on the optimal delay of investment is sizable this implies that the rate of aggregate investment will depend on both the level of the real interest rate and the degree of interest rate uncertainty furthermore it is not necessarily true that investment rises with a fall in interest rates copyright 1992 by university of chicago press

pricing contingent claims under interest rate and asset price risk this paper presents a general framework for pricing contingent claims under interest rate and asset price uncertainty the framework extends ho and lee s 1986 valuation framework by allowing not only future interest rates but also future asset prices to depend on the current term structure of interest rates the approach is shown to provide risk neutral valuation relationships that are consistent with the initial term structure of interest rates and can be applied to valuation of a broad class of assets including stock options convertible bonds and junk bonds

expected life time utility and hedging demands in a partially observable economy this paper analyzes the expected life time utility and the hedging demands in an exchange only representative agent general equilibrium under incomplete information we derive an expression for the investor s expected life time utility and analyze his hedging demands for intertemporal changes in the stochastic unobservable growth of the endowment process and the changing quality of information regarding these changes the hedging demands consist of two components which could work in opposite directions so that a conservative consumer may end up having positive hedging demands our results are qualitatively different from those prevailing under constant growth cf brennan m j 1998 the role of learning in dynamic portfolio decisions european finance review 1 295 306 ziegler a 2003 incomplete information and heterogeneous beliefs in continuous time finance springer berlin chapter 2

pricing interest rate derivative securities this article shows that the one state variableinterest rate models of vasicek 1977 and cox ingersoll and ross 1985b can be extended sothat they are consistent with both the current termstructure of interest rates and either the currentvolatilities of all spot interest rates or the currentvolatilities of all forward interest rates theextended vasicek model is shown to be very tracta ble analytically the article compares option pricesobtained using the extended vasicek model withthose obtained using a number of other models

pricing mortgage default and foreclosure delay this paper extends current mortgage pricing models to recognize the impact that delays between default and foreclosure have on the value of default to the borrower and the resulting value of the mortgage to investors the model explicitly captures potential costs through postforeclosure deficiency judgments and benefits in the elimination of negative equity and free rent that must be weighed at the time of default in determining whether the ultimate put option via allowing foreclosure is in the money the results provide policy implications concerning the operation of the fha insurance program copyright 1997 by ohio state university press

optimal taxation and human capital policies over the life cycle this paper derives optimal income tax and human capital policies in a life cycle model with risky human capital the government faces asymmetric information regarding agents ability its evolution and labor supply when the wage elasticity with respect to ability is increasing in human capital the optimal subsidy involves less than full deductibility of human capital expenses on the tax base and falls with age income contingent loans or a deferred deductibility scheme can implement the optimum numerical results suggest that full deductibility of expenses is close to optimal and that simple linear age dependent policies perform very well

spanning and completeness in markets with contingent claims abstract we characterize financial markets that are complete or that contain portfolios which span all measurable functions of a particular asset payoffs either finite and infinite dimensional these results are then employed to describe the extent to which options trading is sufficient to complete markets to investigate the existence of efficient funds and to establish the extent of market completeness required to ensure the unanimity and irrelevance results of modern corporation finance

on the theory of international currency portfolios abstract the paper develops a general equilibrium theory of the optimal currency composition of international bond portfolios like the partial equilibrium portfolio balance literature of the 1980s the theory emphasizes the critical roles of government debt and government balance sheet operations in the determination of portfolios prices and allocations consistent with empirical findings optimal foreign currency positions are found to be small with their size decreasing with exchange rate volatility while optimal domestic currency positions are large and increasing with domestic interest rates a large open market purchase of domestic currency bonds from private households lowers domestic interest rates

hedging demands in hedging contingent claims minimum variance hedging of a contingent claim in discrete time is suboptimal when the contingent claim is hedged for multiple periods and the objective is to maximize the expected utility of cumulative hedging errors this is because the hedging errors are not independent the difference between a minimum variance hedge and the optimal multiperiod hedge is called the hedging demand and depends on the hedger s preferences the characteristics of the contingent claim the trading frequency and horizon and most importantly the joint distribution of the contingent claim and the underlying security prices since modeling this joint distribution is empirically controversial i examine nonparametrically the economic importance of hedging demands in the case of hedging standard poor s 500 index options

gain loss asymmetric stochastic differential utility abstract this study examines a gain loss asymmetric utility in continuous time in which the investor discounts their utility gain by more than the utility loss by employing the theory of stochastic differential utility the model allows an endogenously time varying subjective discount rate in addition the model can express various forms of utility functions including a version of the epstein zin utility under the model even if the state variables do not have any jump in their paths the optimal consumption wealth ratio and portfolio weight can change non smoothly

moment based estimation of stochastic volatility abstract this paper makes use of the distributional information contained in high frequency data to test for the specification of the functional form of the volatility process within the class of stochastic volatility models it s calculus is implemented in order to obtain the first and second conditional moment of the driving stochastic differential equation for the volatility process these analytical expressions are augmented by their lag and lag squared and are used to form the corresponding gmm estimator the base case stochastic volatility model is extended to allow for the leverage effect and jumps in returns empirical estimation confirms the presence of fast mean reversion in volatility and jumps in returns for the 5 min s p 500 stock market index further estimation results also seem to indicate the presence of jumps in the volatility process that are correlated to the jumps in returns

comparative dynamics of an equilibrium intertemporal asset pricing model this paper uses recursive competitive theory to develop a general equilibrium asset pricing model in this framework all prices and rates of return are endogenously determined thus enabling us to analyze the effects of changes in preferences technological uncertainty and expectations on the structure of security prices in particular we focus on how the market risk premium varies with changes in the underlying economic environment an issue which other asset pricing models have chosen not to address

international investment barriers in general equilibrium abstract this paper examines quantitative international investment barriers in a general equilibrium model the constraints force otherwise similar agents to hold different portfolios of risky assets we show that this induces lending and borrowing this in turn instroduces a hedging motive against shifts in the interest rate the factors affecting agents portfolio choice the allocation of capital across countries as well as the interest rate are charcterized we conjure that the equilibrium world interest rate will be lower in the constrained situations than with free capital flows

generalized social marginal welfare weights for optimal tax theory this paper proposes to evaluate tax reforms by aggregating money metric losses and gains of different individuals using generalized social marginal welfare weights optimum tax formulas take the same form as standard welfarist tax formulas by simply substitut ing standard marginal social welfare weights with those generalized weights weights directly capture society s concerns for fairness without being necessarily tied to individual utilities suitable weights can help reconcile discrepancies between the welfarist approach and actual tax practice as well as unify in an operational way the most prominent alternatives to utilitarianism such as libertarianism equality of opportunity or poverty alleviation jel d60 d63 h21 h23 i38

beliefs and arbitrage pricing abstract this paper investigates the necessary restriction on investor beliefs implied by a no arbitrage price system in addition stone s theorem is invoked to study the existence of equivalent probability measures and to relate our approach to the existing literature

hedging derivative securities and incomplete markets an e arbitrage approach given a european derivative security with an arbitrary payoff function and a corresponding set of underlying securities on which the derivative security is based we solve the optimal replication problem find a self financing dynamic portfolio strategy involving only the underlying securities that most closely approximates the payoff function at maturity by applying stochastic dynamic programming to the minimization of a mean squared error loss function under markov state dynamics we derive recursive expressions for the optimal replication strategy that are readily implemented in practice the approximation error or e of the optimal replication strategy is also given recursively and may be used to quantify the degree of market incompleteness to investigate the practical significance of these e arbitrage strategies we consider several numerical examples including path dependent options and options on assets with stochastic volatility and jumps