the rotten kid theorem meets the samaritan s dilemma a familiar result in the economic theory of the family is becker s rotten kid theorem this theorem states that altruism by a family member will lead other selfish members to act efficiently from the family viewpoint we extend becker s one period model to two periods and show that parental altruism can result in an inefficiency known in other contexts as the samaritan s dilemma implications of this for transfer arrangements within the family and for the ricardian equivalence theorem are drawn

the limits of central bank policy economic crisis and the challenge of effective solutions the paper examines the development of central bank policy prior to and during the recent financial crisis the argument is made that it contained multiple failures that not only generated constraints on adequately identifying and addressing the crisis but also contributed to that crisis those failures derived from a combination of theory and institutional practice specifically the use of forms of inflationary targeting based on broad adherence to the taylor rule framework and the use of versions of a conventional theoretical macro model ctmm were both problematic this was particularly so in the way policy was focused through issues of the primacy of price stability the institutional arrangements of the central banks were also problematic the division of labour between the central banks and other regulatory bodies and the limited information available within a liberalised finance system hampered efforts to fully appreciate the gravity of the situation partly due to the constraints imposed by the thinking and strategies that had been developed the central banks never got to grips with the fundamental problems of the crisis interest rate policy and liquidity provision were undertaken in ways that steadily radicalised the approaches of the banks but always in a way that was event led and always in ways that could not resolve those fundamental problems the nature of the crisis highlights the importance of transforming the approach and institutional framework of the central banks relatedly it highlights the need for a more keynesian and heterodox approach to economics within decision making bodies at central banks

pricing options on scenario trees abstract we examine valuation procedures that can be applied to incorporate options in scenario based portfolio optimization models stochastic programming models use discrete scenarios to represent the stochastic evolution of asset prices at issue is the adoption of suitable procedures to price options on the basis of the postulated discrete distributions of asset prices so as to ensure internally consistent portfolio optimization models we adapt and implement two methods to price european options in accordance with discrete distributions represented by scenario trees and assess their performance with numerical tests we consider features of option prices that are observed in practice we find that asymmetries and or leptokurtic features in the distribution of the underlying materially affect option prices we quantify the impact of higher moments skewness and excess kurtosis on option prices we demonstrate through empirical tests using market prices of the s p500 stock index and options on the index that the proposed procedures consistently approximate the observed prices of options under different market regimes especially for deep out of the money options

contrast explanation in economics its context meaning and potential in this article we place tony lawson s account of contrast explanation in context lawson s development of it is given meaning both by the roots of the approach in his work on social ontology and the state of economics that provides the grounds for the critique contained in that social ontology this is important because such an approach to explanation is not new most notably van fraassen and garfinkel have developed it in particular ways and for particular purposes within the philosophy of science and social theory setting out the different ways in which the contrastive approach has been developed is useful for identifying what is different about lawson s approach its potential and limits lawson s proposal is more modest and focusses on causal investigation in a manner that flows from his approach to social ontology contrast explanation provides a substitute for controlled experiments and facilitates identifying social mechanisms it also enables exploration of the manifold presuppositions of our explanatory questions we argue that this is a useful and important contribution to overcoming some of the many problems economics faces

forward looking contrast explanation illustrated using the great moderation in reorienting economics lawson introduces the concept of contrast explanation initially defined using the question form why x rather than y where it is a surprising or unexpected outcome that motivates the search for an explanation of the contrast in the following paper i elaborate upon the initial question form asking why the perpetuation of y rather than an alternative possible x this question focuses on relative stability but can be a sceptical or contrarian form from a realist perspective any stability expressed in events as regularity is highly conditional as such underlying the question form is an invitation to explore the instability or vulnerability of order with a view to the ways that order might break down this motivates a forward looking focus of investigation that is particularly appropriate for looking at systemic issues in economics i use the global financial crisis to illustrate the potential here copyright oxford university press

are interest rate options important for the assessment of interest rate risk abstract fixed income options contain substantial information on the price of interest rate volatility risk in this paper we ask if those options will also provide information related to other moments of the objective distribution of interest rates based on dynamic term structure models within the class of affine models we find that interest rate options are useful for the identification of interest rate quantiles two three factor models are adopted and their adequacy to estimate value at risk of zero coupon bonds is tested we find significant difference on the quantitative assessment of risk when options are or not included in the estimation process of each of these dynamic models statistical backtests indicate that bond estimated risk is clearly more adequate when options are adopted although not yet completely satisfactory

the recovery theorem we can only estimate the distribution of stock returns but from option prices we observe the distribution of state prices state prices are the product of risk aversion the pricing kernel and the natural probability distribution the recovery theorem enables us to separate these to determine the market s forecast of returns and risk aversion from state prices alone among other things this allows us to recover the pricing kernel market risk premium and probability of a catastrophe and to construct model free tests of the efficient market hypothesis

recovering probability distributions from option prices this article derives underlying asset risk neutral probability distributions of european options on the s p 500 index nonparametric methods are used to choose probabilities that minimize an objective function subject to requiring that the probabilities are consistent with observed option and underlying asset prices alternative optimization specifications produce approximately the same implied distributions a new and fast optimization technique for estimating probability distributions based on maximizing the smoothness of the resulting distribution is proposed since the crash the risk neutral probability of a three four standard deviation decline in the index about 36 percent 46 percent over a year is about 10 100 times more likely than under the assumption of lognormality recently the increasing popularity of derivatives and some highly publicized failures to control risk have led to increased efforts to find reasonable methods to measure the sensitivity of large institutional derivatives portfolios to extreme events merely because such events are rare is not sufficient to ignore them since on the few occasions when they do occur significant amounts of money can change hands potentially wiping out profits accumulated over long prior periods a key assumption behind methods of estimation is the joint probability distribution of constituent underlying asset returns this has long been a concern of financial economists since probability assumptions are critical to much of their research during the last quarter century heretofore probability distributions of stock market returns have typically been estimated from historical time series unfortunately common hypotheses may not capture the probability of extreme events and the events of interest are rare or may not be present in the historical record even though they are clearly possible

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

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

mood induced variation in risk preferences abstract psychological research links good bad mood with increased decreased risk aversion this relation has been widely documented in experimental setups there has not been however a complementary analysis with real life decisions data this paper fills this gap by testing the relation between mood and risk attitude in capital markets to shed light on that relation we recover risk preferences from capital market data and employ accumulated evidence suggesting that people s mood is correlated with weather conditions corroborating established experimental evidence we find that good bad mood is associated with investors being less more willing to tolerate risk

implied volatility functions empirical tests derman and kani 1994 dupire 1994 and rubinstein 1994 hypothesize that asset return volatility is a deterministic function of asset price and time and develop a deterministic volatility function dvf option valuation model that has the potential of fitting the observed cross section of option prices exactly using s p 500 options from june 1988 through december 1993 we examine the predictive and hedging performance of the dvf option valuation model and find it is no better than an ad hoc procedure that merely smooths black scholes 1973 implied volatilities across exercise prices and times to expiration

aid unpredictability and economic growth summary in this paper we examine the influence of unpredictable aid on a recipient s economic growth if aid amounts vary by year and the changes are unpredictable we expect that this unpredictability decreases aid s growth enhancing effect this naturally raises the questions how large is the influence of aid unpredictability on a recipient s economic growth does unpredictability significantly damage aid s growth enhancing effect our research shows that the impact is significant in a typical case one fifth of aid is wasted due to unpredictability further it is possible that in some cases the aid may be wasted by as much as one third

privacy and time consistent optimal labor income taxation abstract incomplete information is a commitment device for time consistency problems in the context of time consistent optimal labor income taxation privacy can lead to a pareto superior outcome and increases the effectiveness of public education as a second best policy

union egalitarianism as income insurance it is a common observation that unions often try to compress the wage distribution among their members as compared with the productivity distribution a troublesome aspect of standard theories of redistributive unions is the question why high productivity workers choose to enter the union in the first place this paper develops and explores the implications of an alternative insurance rationale for egalitarian wage objectives apart from providing a simple explanation of why heterogeneous union members may agree on egalitarian wage policies it also suggests a more guarded attitude toward the welfare costs of pay compression copyright 1992 by the london school of economics and political science

asset pricing with beliefs dependent risk aversion and learning abstract this paper studies equilibrium in a pure exchange economy with unobservable markov switching growth regimes and beliefs dependent risk aversion bdra risk aversion is stochastic and depends nonlinearly on consumption and beliefs equilibrium is obtained in closed form the market price of risk the interest rate and the stock return volatility acquire new components tied to fluctuations in beliefs a three regime specification is estimated using the generalized method of moments gmm model moments match their empirical counterparts for a variety of unconditional moments including the equity premium stock returns volatility and the correlations between stock returns and consumption and dividends dynamic features of the data such as the countercyclical behaviors of the equity premium and volatility are also captured model volatility provides a good fit for realized volatility a new factor the information risk premium is found to be a strong predictor of future excess returns these results are obtained with an estimated risk aversion fluctuating between 1 44 and 1 93

the predictive power of implied volatility evidence from 35 futures markets abstract using data from 35 futures options markets from eight separate exchanges we test how well the implied volatilities ivs embedded in option prices predict subsequently realized volatility rv in the underlying futures we find that for this broad array of futures options iv performs well in a relative sense for a large majority of the commodities studied the implieds outperform historical volatility hv as a predictor of the subsequently rv in the underlying futures prices over the remaining life of the option indeed in most markets examined regardless of whether it is modeled as a simple moving average or in a garch framework hv contains no economically significant predictive information beyond what is already incorporated in iv these findings add to previous research that has focused on currency and crude oil futures by extending the analysis into a very broad array of contracts and exchanges our results are consistent with the hypothesis that futures options markets in general with their minimal trading frictions are efficient

consequences of aid volatility for macroeconomic management and aid effectiveness we conclude that individual aid sector volatility matters as well as total aid volatility easily the most important contributor to total volatility is debt aid the most volatile aid sectors per se include debt industry and humanitarian and the least include education and health in several sectors volatility appears to have peaked around 2006 within individual countries sector volatility is often corrected for in the following period there are also sometimes knock on effects on other sectors finally we examine the impact of sector aid and aid volatility on school completion rates death rates internet usage and mobile phone subscriptions

statistical arbitrage and securities prices this article introduces the concept of a statistical arbitrage opportunity sao in a finite horizon economy a sao is a zero cost trading strategy for which i the expected payoff is positive and ii the conditional expected payoff in each final state of the economy is nonnegative unlike a pure arbitrage opportunity a sao can have negative payoffs provided that the average payoff in each final state is nonnegative if the pricing kernel in the economy is path independent then no saos can exist furthermore ruling out saos imposes a novel martingale type restriction on the dynamics of securities prices the important properties of the restriction are that it 1 is model free in the sense that it requires no parametric assumptions about the true equilibrium model 2 can be tested in samples affected by selection biases such as the peso problem and 3 continues to hold when investors beliefs are mistaken the article argues that one can use the new restriction to empirically resolve the joint hypothesis problem present in the traditional tests of the efficient market hypothesis in a fairly general environment this article proposes a novel martingaletype restriction on the dynamics of securities prices this restriction has a number of important properties most notably the restriction may be viewed as model free because it requires no parametric assumptions about the true equilibrium model to derive the restriction we rely on the concept of statistical arbitrage a generalization of pure arbitrage a pure arbitrage opportunity pao is a zero cost trading strategy that offers the possibility of a gain with no possibility of a loss as is well known the existence of paos is incompatible with a competitive equilibrium in asset markets the fundamental theorem of the financial theory establishes a link between the absence of paos and the existence of a positive pricing kernel which supports securities prices while the absence of paos is a necessary condition for any equilibrium model this condition alone often yields pricing implications that are too weak to be practically useful for example when valuing options in incomplete markets the no arbitrage bounds on option prices are typically very wide to strengthen pricing implications several recent articles

out of sample performance of discrete time spot interest rate models we provide a comprehensive analysis of the out of sample performance of a wide variety of spot rate models in forecasting the probability density of future interest rates although the most parsimonious models perform best in forecasting the conditional mean of many financial time series we find that the spot rate models that incorporate conditional heteroscedasticity and excess kurtosis or heavy tails have better density forecasts generalized autoregressive conditional heteroscedasticity significantly improves the modeling of the conditional variance and kurtosis whereas regime switching and jumps improve the modeling of the marginal density of interest rates our analysis shows that the sophisticated spot rate models in the existing literature are important for applications involving density forecasts of interest rates

the physical vulnerability to climate change index an index to be used for international policy abstract recent years have seen a sharp increase in the production of indices of vulnerability to climate change most of these indices of vulnerability to climate change have been primarily used for awareness raising purposes rather than for guiding international policy the physical vulnerability to climate change index pvcci proposed in this paper has been designed as an index of exogenous vulnerability not influenced by the present policy of the countries concerned as such it can be used as a criterion for guiding the international allocation of concessional resources in particular those devoted to adaptation as well as for the identification of the countries that are most vulnerable for structural or physical reasons the index has been calculated for 191 countries ldcs sids and african countries have a higher average score however there is a wide disparity in pvcci scores within these three groups of countries implying that a country by country allocation of resources should be used rather than an allocation by country group the findings appear to be robust after comparison of various options

the determinants of asymmetric volatility volatility in equity markets is asymmetric contemporaneous return and conditional return volatility are negatively correlated in this article i develop an asymmetric volatility model where dividend growth and dividend volatility are the two state variables of the economy the model allows both the leverage effect and the volatility feedback effect the two popular explanations of asymmetry the model is estimated by the simulated method of moments i find that both the leverage effect and volatility feedback are important determinants of asymmetric volatility and volatility feedback is significant both statistically and economically the relationship between stock price and its volatility has long interested financial researchers empirically returns and conditional variance of next period s returns are negatively correlated that is negative positive returns are generally associated with upward downward revisions of the conditional volatility this empirical phenomenon is often referred to as asymmetric volatility in the literature see engle and ng 1993 zakoian 1994 and wu and xiao 1999 the presence of asymmetric volatility is most apparent during stock market crashes when a large decline in stock price is associated with a significant increase in market volatility formal econometric models have been developed by researchers to capture asymmetric volatility for example asymmetric arch models of nelson 1991 and glosten jagannathan and runkle 1993 have been found to significantly outperform their counterparts that do not accommodate the asymmetry moreover continuous time stochastic volatility models generally produce estimates of a negative correlation between return and return volatility bakshi cao and chen 1997 and bates 1997 for a review of the literature on asymmetric volatility see bekaert

effects of the volatility smile on exchange settlement practices the hong kong case abstract the well documented volatility smile phenomenon in the us options market has affected the option settlement practices of other markets to settle hang seng index hsi options the hong kong stock exchange artificially builds in a piecewise linear smile or sneer volatility function which is determined daily by market makers rather than directly by market forces in this study we investigate the time varying settlement function and find the following economic determinants of the volatility function lag parameters current day hsi returns the distribution of hsi returns transaction costs as proxied by the bid ask spread and the monday effect for evaluation purposes we use as a benchmark the estimated piecewise linear volatility function as directly driven by market forces the comparison analyses show that base volatilities set by market makers run somewhat high while downside slopes are not steep enough this results in the overpricing of the lion s share of traded options an economic determinants analysis of market force driven parameters reveals that market makers can better align artificial volatility parameters both by reducing reliance on the function parameters of prior days and by more precisely accounting for current day hsi returns option time to maturity bid ask spreads and buying pressure

computing the market price of volatility risk in the energy commodity markets abstract in this paper we demonstrate the need for a negative market price of volatility risk to recover the difference between black scholes black f scholes m 1973 the pricing of options and corporate liabilities journal of political economy 81 637 654 black black f 1976 studies of stock price volatility changes in proceedings of the 1976 meetings of the business and economics statistics section american statistical association pp 177 181 implied volatility and realized term volatility initially using quasi monte carlo simulation we demonstrate numerically that a negative market price of volatility risk is the key risk premium in explaining the disparity between risk neutral and statistical volatility in both equity and commodity energy markets this is robust to multiple specifications that also incorporate jumps next using futures and options data from natural gas heating oil and crude oil contracts over a 10 year period we estimate the volatility risk premium and demonstrate that the premium is negative and significant for all three commodities additionally there appear distinct seasonality patterns for natural gas and heating oil where winter withdrawal months have higher volatility risk premiums computing such a negative market price of volatility risk highlights the importance of volatility risk in understanding priced volatility in these financial markets

state price densities under heterogeneous beliefs the smile effect and implied risk aversion abstract it has been widely noted in the empirical literature that state price densities implicit in financial asset prices are not log normal this paper shows that this phenomenon can be caused by heterogeneity in investors beliefs it derives the state price density under heterogeneous beliefs in closed form and demonstrates that heterogeneous beliefs can give rise to multimodal state price densities consequences for the smile effect in implied option volatility and for measures of risk aversion inferred from empirical state price densities are discussed

optimum taxation with errors in administration abstract the paper compares the welfare levels which can be achieved by two distinct tax regimes lump sum taxation where one attempts to identify individuals and allocate transfers or subsidies on the basis of characteristics and income taxation where characteristics are not observed but personal incomes are measured and taxed where there are no errors in classifying individuals lump sum taxation is superior but where mistakes are made in the allocation of lump sum grants or subsidies income taxation may be more attractive the level of errors where the regimes are equally desirable in terms of social welfare is computed in simple models following that of feldstein 1973 where there is strong aversion to inequality then income taxation becomes preferable at quite small errors in analysing income taxation it is shown that in the feldstein model with endogenous wages the marginal tax rate in optimum income taxation on the more skilled is negative and that on the less skilled is positive in contrast to the standard results see seade 1977 with exogenous wages

investment in education and the time inconsistency of redistributive tax policy time inconsistency of tax policy is shown to arise in a setting where households differ in their ability to accumulate wealth and where the government has redistributional objectives it is assumed that wealth accumulation takes the form of human capital acquired through education the government is precluded from redistributing to a first best optimum by a self selection constraint the second best is shown to be time inconsistent in the time consistent optimum households underinvest in education an argument can be made for public intervention in the provision of education

recovering risk neutral densities from option prices a new approach in this paper we present a new method of approximating the risk neutral density rnd from option prices based on the c type gram charlier series expansion gcse of a prob ability density function the exponential form of this type of gcse guarantees that it will always give positive values of the risk neutral probabilities and it can allow for stronger deviations from normality which are two drawbacks of the a type gcse used in practice to evaluate the performance of the suggested expansion of the rnd the paper presents simulation and empirical evidence

the pricing of jump propagation evidence from spot and options markets this paper examines the joint time series of the s p 500 index and its options with a two factor hawkes jump diffusion model that captures jump propagation i e the phenomenon in which the strike of one jump substantially raises the probability for more to follow the propagation effect uncovered from the joint data is severe but short lived on average this component takes up more than two thirds of the total jump risks our jump specification proves crucial not only in reconciling the dynamics implied from the joint data but also in explaining the time series of option implied volatility skew the online appendix is available at https doi org 10 1287 mnsc 2017 2885 this paper was accepted by lauren cohen finance

the finite moment log stable process and option pricing we document a surprising pattern in s p 500 option prices when implied volatilities are graphed against a standard measure of moneyness the implied volatility smirk does not flatten out as maturity increases up to the observable horizon of two years this behavior contrasts sharply with the implications of many pricing models and with the asymptotic behavior implied by the central limit theorem clt we develop a parsimonious model which deliberately violates the clt assumptions and thus captures the observed behavior of the volatility smirk over the maturity horizon calibration exercises demonstrate its superior performance against several widely used alternatives

nonparametric estimation of american options exercise boundaries and call prices abstract unlike european type derivative securities there are no simple analytic valuation formulas for finite lived american options even when the underlying asset price has constant volatility the early exercise feature considerably complicates the valuation of american contracts the strategy taken in this paper is to rely on nonparametric statistical methods using market data to estimate the call prices and the exercise boundaries a comparison is made with parametric constant volatility model based prices and exercise boundaries the paper focuses on assessing the adequacy of conventional formulas by comparing them to nonparametric estimates we use daily market option prices and exercise data on the s p100 contract the most actively traded american option contract we find large discrepancies between the parametric and nonparametric call prices and exercise boundaries we also find remarkable similarities of the nonparametric estimates before and after the crash of october 1987

a theory of the welfare state the welfare state can be seen as an insurance device that makes lifetime careers safer increases risk taking and suffers from moral hazard effects adopting this view the paper studies the trade off between average income and inequality evaluating redistributive equilibria from an allocative point of view it studies the problem of optimal redistributive taxation with tax induced risk taking and shows that constant returns to risk taking are likely to imply a paradox where more redistribution results in more post tax inequality in general optimal taxation will either imply that the redistribution paradox is present or that the economy operates at a point of its efficiency frontier where more inequality implies a lower average income redistribution welfare state

aid selectivity according to augmented criteria a dominant trend in the literature maintains that donor assistance should be targeted to poor countries with sound institutions and policies in this context donor selectivity refers to what extent aid is allocated according to the principles of this canonical model this paper shows that it is legitimate for donors to simultaneously use other selectivity criteria corresponding either to expected factors of aid effectiveness or to handicaps to development it is notably argued that vulnerability to exogenous shocks and low level of human capital should be considered as selectivity criteria taking these other criteria into account dramatically changes the assessment of donor selectivity

aid volatility and donor recipient characteristics in difficult partnership countries one factor limiting aid effectiveness is its volatility we examine aid volatility in 66 countries over 1975 2004 paying particular attention to the characteristics of difficult partnership countries and making a distinction between sector aid and total aid we explore whether weak recipient institutions and policies are associated with greater volatility allowing for differences in donor characteristics institutional quality and macroeconomic stability affect the stability of all kinds of aid as does reliance on a small number of donors however the relative importance of these effects varies across different aid types

the nature of market growth risk and return in the model of asset appreciation advanced here the market economy and the market of asset claims on the economy are modeled as organic or exponential growth processes similar to those commonly seen in nature and the biological sciences in dempsey s organic growth model of appreciation dogma investors have a log wealth utility function within the framework the market risk premium is derived as the premium that balances supply and demand among risky and risk free assets the model indicates that the premium is less than is indicated by ex post returns observed on u s stock markets the model is consistent however with empirical observations that idiosyncratic risk and small company size are rewarded by the markets in terms of the model investors choose to allocate their portfolios long in both the risky market and the risk free asset furthermore their portfolios are independent of the investment time horizon

an empirical test of pricing kernel monotonicity summary a large class of asset pricing models predicts that securities which have high payoffs when market returns are low tend to be more valuable than those with high payoffs when market returns are high more generally we expect the projection of the stochastic discount factor on the market portfolio that is the discounted pricing kernel evaluated at the market portfolio to be a monotonically decreasing function of the market portfolio numerous recent empirical studies appear to contradict this prediction the non monotonicity of empirical pricing kernel estimates has become known as the pricing kernel puzzle in this paper we propose and apply a formal statistical test of pricing kernel monotonicity we apply the test using 17 years of data from the market for european put and call options written on the s p 500 index statistically significant violations of pricing kernel monotonicity occur in a substantial proportion of months suggesting that observed non monotonicities are unlikely to be the product of statistical noise copyright 2014 john wiley sons ltd

aid policies and growth the authors of this paper use a new database on foreign aid to examine the relationships among foreign aid economic policies and growth of per capita gdp in panel growth regressions for 56 developing countries and 6 four year periods 1970 93 they find that the policies that have a great effect on growth are those related to fiscal surplus inflation and trade openness they construct an index for those three policies and have that index interact with foreign aid they have instruments for both aid and aid interacting with policies they find that aid has a positive impact on growth in developing countries with good fiscal monetary and trade policies in the presence of poor policies aid has no positive effect on growth this result is robust in a variety of specifications which include or exclude middle income countries include or exclude outliers and treat policies as exogenous or endogenous they examine the determinants of policy and find no evidence that aid has systematically affected policies either for good or for ill they estimate an aid allocation equation and show that any tendency for aid to reward good policies has been overwhelmed by donors pursuit of their own strategic interests in a counterfactual they reallocate aid reduce the role of donor interests and increasing the importance of policy such a reallocation would have a large positive effect on developing countries growth rates

sv mixture models with application to s p 500 index returns understanding both the dynamics of volatility and the shape of the distribution of returns conditional on the volatility state is important for many financial applications a simple single factor stochastic volatility model appears to be sufficient to capture most of the dynamics it is the shape of the conditional distribution that is the problem this paper examines the idea of modeling this distribution as a discrete mixture of normals the flexibility of this class of distributions provides a transparent look into the tails of the returns distribution model diagnostics suggest that the model sv mix does a good job of capturing the salient features of the data in a direct comparison against several affine jump models sv mix is strongly preferred by akaike and schwarz information criteria

union strategy and optimal direct taxation restrictions on work hours are more important in countries with a large welfare state we show that this empirical observation is consistent with the strategic effects of such restrictions in a welfare state in the context of optimal direct taxation in the tradition of mirrlees 1971 our results also apply to non welfarist states which have income redistribution but not in purely extortionary states

option pricing under time varying risk aversion with applications to risk forecasting abstract we present a two factor option pricing model which parsimoniously captures the difference in volatility persistences under the historical and risk neutral probabilities the model generates an s shaped pricing kernel that exhibits time varying risk aversion we apply our model for two purposes first we analyze the risk preference implied by s p500 index options during 2001 2009 and find that risk aversion level strongly increases during stressed market conditions second we apply our model for value at risk var forecasts during the subprime crisis period and find that it outperforms several leading var models

adaptive expectations and stock market crashes a theory is developed that explains how stocks can crash without fundamental news and why crashes are more common than frenzies a crash occurs via the interaction of rational and naive investors naive traders believe that prices follow a random walk with serially correlated volatility their expectations of future volatility are formed adaptively when the market crashes naive traders sell stock in response to the apparent increase in volatility since rational traders are risk averse as well a lower price is needed to clear the market the crash is a self fulfilling prophecy frenzies cannot occur in this model

good jobs bad jobs and redistribution we analyse the question of optimal taxation in a dual economy when the policy maker is concerned about the distribution of labour income income inequality is caused by the presence of sunk capital investments which creates a good jobs sector due to the capture of quasi rents by trade unions with strong unions and high planner preference for income equality the optimal policy is a combination of investment subsidies and progressive income taxation if unions are weaker the policy maker may instead choose to tax investment

bounds and prices of currency cross rate options abstract this paper derives the pricing bounds of a currency cross rate option using the option prices of two related dollar rates via a copula theory and presents the analytical properties of the bounds under the gaussian framework our option pricing bounds are useful because 1 they are general in the sense that they do not rely on the distribution assumptions of the state variables or on the selection of the copula function 2 they are portfolios of the dollar rate options and hence are potential hedging instruments for cross rate options and 3 they can be applied to generate bounds on deltas the empirical tests suggest that there are persistent and stable relationships between the market prices and the estimated bounds of the cross rate options and that our option pricing bounds obtained from the market prices of options on two dollar rates and the historical correlation of two dollar rates are highly informative for explaining the prices of the cross rate options moreover the empirical results are consistent with the predictions of the analytical properties under the gaussian framework and are robust in various aspects

unconditional return disturbances a non parametric simulation approach abstract simulation methods are extensively used in asset pricing and risk management the most popular of these simulation approaches the monte carlo requires model selection and parameter estimation in addition these approaches can be extremely computer intensive historical simulation has been proposed as a non parametric alternative to monte carlo this approach is limited to the historical data available in this paper we propose an alternative historical simulation approach given a historical set of data we define a set of standardized disturbances and we generate alternative price paths by perturbing the first two moments of the original path or by reshuffling the disturbances this approach is either totally non parametric when constant volatility is assumed or semi parametric in presence of garch 1 1 volatility without a loss in accuracy it is shown to be much more powerful in terms of computer efficiency than the monte carlo approach it is also extremely simple to implement and can be an effective tool for the valuation of financial assets we apply this approach to simulate pay off values of options on the s p 500 stock index for the period 1982 2003 to verify that this technique works the common back testing approach was used the estimated values are insignificantly different from the actual s p 500 options payoff values for the observed period

optimal income transfer programs intensive versus extensive labor supply responses this paper analyzes optimal income transfers for low incomes labor supply responses are modeled along the intensive margin intensity of work on the job and along the extensive margin participation into the labor force when behavioral responses are concentrated along the intensive margin the optimal transfer program is a classical negative income tax program with a substantial guaranteed income support and a large phasing out tax rate however when behavioral responses are concentrated along the extensive margin the optimal transfer program is similar to the earned income tax credit with negative marginal tax rates at low income levels and a small guaranteed income carefully calibrated numerical simulations are provided

optimal option portfolio strategies deepening the puzzle of index option mispricing traditional methods of asset allocation such as mean variance optimization are not adequate for option portfolios because the distribution of returns is non normal and the short sample of option returns available makes it difficult to estimate their distribution we propose a method to optimize a portfolio of european options held to maturity with a myopic objective function that overcomes these limitations in an out of sample exercise incorporating realistic transaction costs the portfolio strategy delivers a sharpe ratio of 0 82 with positive skewness this performance is mostly obtained by exploiting mispricing between options and not by loading on jump or volatility risk premia

errors in implied volatility estimation estimating implied volatility by inverting the black scholes formula is subject to considerable error when option characteristics are observed with plausible errors especially for options away from the money large changes in volatility produce small changes in option prices conversely small errors in option prices and other option characteristics produce large errors in implied volatilities in the presence of small measurement errors unobserved truncation of option prices that violate lower bounds for absence of arbitrage can also lead to systematic volatility smiles the paper proposes feasible gls estimators that reduce the noise and bias in implied volatility estimates

implied exchange rate distributions evidence from otc option markets abstract this paper uses a rich new dataset of option prices on the dollar mark dollar yen and key ems cross rates to extract the entire risk neutral probability density function pdf over horizons of 1 and 3 months we compare three alternative smoothing methods cubic splines an implied binomial tree trimmed and untrimmed and a mixture of lognormals for transforming option data into the pdf despite their methodological differences the three approaches lead to a similar pdf clearly distinct from the lognormal benchmark and typically characterized by skewness and leptokurtosis we then document a striking positive correlation between skewness in these pdfs and the spot rate the stronger a currency the more expectations are skewed towards a further appreciation of that currency we interpret this finding as a rejection that innovations in these exchange rates are independent of the level or characteristic of a credible target zone explicit or implicit instead this positive correlation is consistent with target zones with endogenous realignment risk we discuss two interpretations of our results on skewness when a currency is stronger the actual probability of further large appreciation is higher or because of risk such states are valued more highly

volatility of development aid from the frying pan into the fire summary the paper building on the authors previous analysis examines the relative volatility of aid flows into developing countries and their domestic revenue using new data and three alternative measures of aid instability relative volatility vis a vis fiscal revenue unpredictability of aid disbursement relative to commitments and failure of aid to smooth fluctuations in aggregate income it finds that the volatility of aid flows is still much greater than that of domestic revenue and that this difference is not decreasing especially in very poor aid dependent countries this high volatility of inflows makes the macroeconomy hard to manage further the influence of aid has been procyclical and not countercyclical aid has failed to act either as a stabilizing force or as an insurance mechanism we argue that to counter these unwelcome trends donors need to be able to respond more speedily and effectively to large adverse shocks and their conditionalities need to become more flexible possibilities explicitly discussed elsewhere in this special section

vix derivatives hedging and vol of vol risk we study the empirical hedging performance of alternative vix option pricing models recent advances in the literature find evidence of asymmetric volatility of volatility similar to the leverage effect in equity markets stochastic mean reversion and jumps using such findings in our model framework we show that while sophisticated models have superior pricing performance and can explain a range of stylized facts in the vix derivatives market their hedging performance is inferior to a simple black model hedge we also study the empirical performance of regime dependent hedge ratio adjustments commonly applied in equity markets

a simple nonparametric approach to derivative security valuation canonical valuation uses historical time series to predict the probability distribution of the discounted value of primary assets discounted prices plus accumulated dividends at any future date then the axiomatically rationalized maximum entropy principle is used to estimate risk neutral equivalent martingale probabilities that correctly price the primary assets as well as any predesignated subset of derivative securities whose payoffs occur at this date valuation of other derivative securities proceeds by calculation of its discounted risk neutral expected value both simulation and empirical evidence suggest that canonical valuation has merit since the advent of the justly celebrated black scholes option pricing formula intense interest has focused on testing its implications there is consensus

income taxation and job market signaling abstract this paper develops a model of taxation with asymmetric information between the worker and the employer as well as between the worker and the tax collector we show that if the informational asymmetry in the labour market is solved through signaling implications for taxation are strong taxing the signal directly as well as imposing a progressive tax on income are both shown to have favourable welfare consequences locally in contrast to the results obtained for the progressive income tax we show that taxing the signal directly is likely to reduce other distortions the optimal tax fully exploits the possibilities to tax the signal directly before using progression

the anarchy of numbers aid development and cross country empirics the recent literature contains many stories of how foreign aid affects economic growth aid raises growth in countries with good policies or with difficult economic environments or outside the tropics or on average but with diminishing returns the diversity of the results suggests that many are fragile seven important aid growth papers are tested for robustness using 14 minimally arbitrary tests deriving mainly from differences among the studies themselves this approach investigates the importance of potentially arbitrary specification choices while minimizing the arbitrariness in testing choices all of the results appear fragile especially to sample expansion

aid policies and growth comment in an extraordinarily influential paper craig burnside and david dollar 2000 p 847 find that aid has a positive impact on growth in developing countries with good fiscal monetary and trade policies but has little effect in the presence of poor policies this finding has enormous policy implications the burnside and dollar 2000 henceforth bd result provides a role and strategy for foreign aid if aid stimulates growth only in countries with good policies this suggests that 1 aid can promote economic growth and 2 it is crucial that foreign aid be distributed selectively to countries that have adopted sound policies international aid agencies public policy makers and the press quickly recognized the importance of the bd findings this paper reassesses the links between aid policy and growth using more data the bd data end in 1993 we reconstruct the bd database from original sources and thus 1 add additional countries and observations to the bd data set because new information has become available since they conducted their analyses and 2 extend the data through 1997 thus using the bd methodology we reexamine whether aid influences growth in the presence of good policies given our focus on retesting bd we do not summarize the vast pre bd literature on aid and growth we just note that there was a long and inconclusive literature that was hampered by limited data availability debates about the mechanisms through which aid would affect growth and disagreements over econometric specification see gustav f papanek 1972 robert cassen 1986 paul mosley et al 1987 peter boone 1994 1996 and henrik hansen and finn tarp s 2000 review since bd found that aid boosts growth in good policy environments there have been a number of other papers reacting to their results including paul collier and jan dehn 2001 carljohan dalgaard and hansen 2001 patrick guillaumont and lisa chauvet 2001 hansen and tarp 2001 robert lensink and howard white 2001 and collier and dollar 2002 these papers conduct useful variations and extensions some of which had already figured in the pre bd literature such as introducing additional control variables using nonlinear specifications etc some of these papers confirm the message that aid only works in a good policy environment while others drive out the aid policy interaction term with other variables this literature has the usual limitations of choosing a specification without clear guidance from theory which often means there are more plausible specifications than there are data points in the sample we differentiate our paper from these others by not deviating from the bd specification thus we do not test the robustness of the results to an unlimited number of variations but instead maintain the bd methodology this paper conducts a very simple robustness check by adding new data that were unavailable to bd thus we expand the sample used over their time period and extend the data from 1993 to 1997 easterly department of economics new york university 269 mercer street new york ny 10003 center for global development and national bureau of economic research e mail william easterly nyu edu levine department of finance carlson school of management university of minnesota 321 19th avenue south minneapolis mn 55455 and national bureau of economic research e mail rlevine csom umn edu roodman center for global development 1776 massachusetts avenue nw washington dc 20036 e mail droodman cgdev org we are grateful to craig burnside for supplying data and assisting in the reconstruction of previous results without holding him responsible in any way for the work in this paper thanks also to francis ng and prarthna dayal for generous assistance with updating the sachs warner openness variable and to three anonymous referees craig burnside and henrik hansen for helpful comments 1 see for instance the world bank 1994 2001 2002 the u k department for international development 2000 president george w bush s speech march 16 2002 the announcement by the white house on creating the millennium challenge corporation white house 2002 as well as a washington post editorial february 9 2002 a financial times column by alan beattie march 11 2002 and the economist march 16 2002

a methodology for assessing model risk and its application to the implied volatility function model we propose a methodology for assessing model risk and apply it to the implied volatility function ivf model this is a popular model among traders for valuing exotic options our research is different from other tests of the ivf model in that we reflect the traders practice of using the model for the relative pricing of exotic and plain vanilla options at one point in time we find little evidence of model risk when the ivf model is used to price and hedge compound options however there is significant model risk when it is used to price and hedge some barrier options

a model intervenes the many faces of moral hazard this article builds on advances in social ontology to develop a new understanding of how mainstream economic modelling affects reality we propose a new framework for analysing and describing how models intervene in the social sphere this framework allows us to identify and articulate three key epistemic features of models as interventions specificity portability and formal precision the second part of the article uses our framework to demonstrate how specificity portability and formal precision explain the use of moral hazard models in a variety of different policy contexts including worker compensation schemes bank regulation and the euro sovereign debt crisis

how to take into account vulnerability in aid allocation criteria and lack of human capital as well improving the performance based allocation summary this paper considers why and how the performance based allocation pba used in multilateral development banks and in particular at ida could be improved by taking the structural handicaps of eligible countries into account the pba relies on a debatable definition of performance it does not meet the equity concern raised by the existence of structural handicaps to growth it neglects the lessons of the aid effectiveness literature finally it suffers from some opacity we show how it is possible to increase the share of specific groups of countries such as sub saharan africa or post conflict states in a transparent manner

the strategic advantage of being poor private and public provision of public goods when people know that a public good is to be privately provided in the future economic behaviour may change in periods before the one with the private provision game individuals have a distortionary incentive to reduce their disposable income so as to shift the burden of provision to others the incentive is eliminated if the government provides a sufficient amount of the public good in a second best world private provision of public goods has been claimed to be a reasonably good alternative to public provision this claim needs to be reconsidered in the light of these results

constraints on the choice of work hours agency versus specific capital lifetime contracts imply that at a given time wages and value of marginal product vmp will diverge the contract will specify hours as well as wages since firms will desire to prevent workers from working more when the wage is greater than vmp and from working less when the wage is less than vmp if hours are set efficiently workers will face binding hours constraints the agency model and the firm specific capital models make opposite predictions regarding the relation between work hours constraints and job tenure we test these predictions our results indicate that neither model explains the observed pattern of hours constraints

aid and growth regressions this paper examines the relationship between foreign aid and growth in real gdp per capita as it emerges from simple augmentations of popular cross country growth specifications it is shown that aid in all likelihood increases the growth rate and this result is not conditional on good policy there are however decreasing returns to aid and the estimated effectiveness of aid is highly sensitive to the choice of estimator and the set of control variables when investment and human capital are controlled for no positive effect of aid is found yet aid continues to impact on growth via investment we conclude by stressing the need for more theoretical work before this kind of cross country regressions are used for policy purposes

dynamic income taxation redistribution and the ratchet effect abstract in this paper we extend the classic optimum linear income tax model to a twice repeated game a utilitarian policy maker decides on the second period tax system on the basis of observed first period behaviour we summarise our findings as follows first the static optimal linear tax results cannot be expected to hold in a dynamic setting second more productive households are likely to mimic the behaviour of less productive households third the optimal dynamic first period tax rate might be negative then income is redistributed from low to high income households fourth if the utility function is well behaved then the optimal dynamic first period tax rate is lower than the optimal static tax rate fifth if the optimal static tax rate separates then the dynamic and the static optimal tax rates coincide sixth if a zero tax rate separates then the optimal dynamic tax rate is positive

rat race redux adverse selection in the determination of work hours in law firms this paper describes an organizational setting in which professional employees are required to work inefficiently long hours the focus of the authors investigation is large law firms the income sharing that characterizes legal partnerships creates incentives to promote associates who have a propensity to work very hard law firms use indicators of this propensity especially an associate s record of billable hours in promotion decisions reliance upon work hours as an indicator leads to a rat race equilibrium in which associates work too many hours the authors find evidence in support of this conclusion with data they collected from two large law firms copyright 1996 by american economic association

cross country evidence on the link between volatility and growth this paper presents empirical evidence against the standard dichotomy in macroeconomics that separates growth from the volatility of economic fluctuations in a sample of ninety two countries as well as a sample of oecd countries the authors find that countries with higher volatility have lower growth the addition of standard control variables strengthens the negative relationship the authors also find that government spending induced volatility is negatively associated with growth even after controlling for both time and country fixed effects copyright 1995 by american economic association

aid and performance a reassessment two visions of aid effectiveness and allocation are compared the first corresponding to the new aid paradigm argues that aid is only effective if domestic policies are appropriate the second in contrast argues that aid effectiveness depends on the external and climatic environment the worse this environment or the more vulnerable the recipient countries the greater the effectiveness of aid cross sectional econometric tests related to gdp growth on two 12 year pooled periods clearly favour the second view the two views can be reconciled through the principle of performance based aid allocation where performance is defined as outcomes adjusted for the impact of environmental factors performance can then be measured in several manners which are subject to comparison one approach would lead one to allocate more aid the worse the external environment is for a given policy and the better the policy is for a given environment

self selection and pareto efficient taxation abstract this paper analyses the set of pareto efficient tax structures the formulation of the problem as one of self selection not only shows more clearly the similarity between this problem and a number of other problems such as the optimal pricing of a monopolist which have recently been the subject of extensive research but also allows the derivation of a number of new results we establish i under fairly weak conditions randomization of tax structures is desirable ii if different individuals are not perfect substitutes for one another in production then the general equilibrium effects until now largely ignored in the literature of changes in the tax structure may be dominant in determining the optimal tax structure in particular if the relative wage of high ability and low ability individuals depends on the relative supplies of labor the optimal tax structure entails a negative marginal tax rate on the high ability individuals and a positive marginal tax rate on the low ability individuals the marnitude of which depends on the elasticity of substitution iii if individuals differ in their preferences pareto efficient taxation may entail negative marginal tax rates for high incomes while iv if wage income is stochastic the marginal tax rate at the upper end may be 100 our analysis thus makes clear that the main qualitative properties of the optimal tax structure to which earlier studies called attention are not robust to these attempts to make the theory more realistic