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

bonus payments as an anti corruption instrument a theoretical approach abstract we analyse bonus payments for officials who transfer payments truthfully to the government rather than collecting bribes we show that optimised bonus payments are always beneficial to the government making them a more effective anti corruption measure than simple wage increases

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

the economist s approach to the problem of corruption summary this paper will first distinguish between the non economist s approach to corruption largely on the basis of public morals and norms and the economist s approach in terms of incentives and organization i then discuss why otherwise similar countries may end up with different equilibrium levels of corruption why such equilibria tend to persist and why corruption in some countries seems to be more damaging to the economy than in others i then try to derive some policy lessons 2005 elsevier ltd all rights reserved

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

roughing it up including jump components in the measurement modeling and forecasting of return volatility a rapidly growing literature has documented important improvements in financial return volatility measurement and forecasting via use of realized variation measures constructed from high frequency returns coupled with simple modeling procedures building on recent theoretical results in barndorff nielsen and shephard 2004a 2005 for related bi power variation measures the present paper provides a practical and robust framework for non parametrically measuring the jump component in asset return volatility in an application to the dm exchange rate the s p500 market index and the 30 year u s treasury bond yield we find that jumps are both highly prevalent and distinctly less persistent than the continuous sample path variation process moreover many jumps appear directly associated with specific macroeconomic news announcements separating jump from non jump movements in a simple but sophisticated volatility forecasting model we find that almost all of the predictability in daily weekly and monthly return volatilities comes from the non jump component our results thus set the stage for a number of interesting future econometric developments and important financial applications by separately modeling forecasting and pricing the continuous and jump components of the total return variation process

in view of ratification governmental preferences and domestic constraints at the amsterdam intergovernmental conference the bargaining product of the amsterdam intergovernmental conference the amsterdam treaty dwindled down the draft proposal to a consensus set of all fifteen member states of the european union eu using the two level concept of international bargains we provide a thorough analysis of how this consensus set was reached by issue subtraction with respect to domestic ratification constraints drawing on data sets covering the positions of all negotiating actors and ratifying national political parties we first highlight the differences in the amsterdam ratification procedures in the fifteen member states of the eu this analysis allows us to compare the varying ratification difficulties in each country second our empirical analysis of the treaty negotiations shows that member states excluded half of the amsterdam bargaining issues to secure a smooth ratification because member states with higher domestic ratification constraints performed better in eliminating uncomfortable issues at the amsterdam intergovernmental conference issue subtraction can be explained by the extent to which the negotiators were constrained by domestic interests

semi parametric comparison of stochastic volatility models using realized measures this paper proposes a procedure to test for the correct specification of the functional form of the volatility process within the class of eigenfunction stochastic volatility models the procedure is based on the comparison of the moments of realized volatility measures with the corresponding ones of integrated volatility implied by the model under the null hypothesis we first provide primitive conditions on the measu rement error associated with the realized measure which allow to construct asymptotically valid specification tests then we establish regularity conditions under which the considered realized measures namely realized volatility bipower variation and modified subsampled realized volatility satisfy the given primitive assumptions finally we provide an empirical illustration based on thr ee stocks from the dow jones industrial average 2006 the review of economic studies limited

managing domestic differences in international negotiations the strategic use of internal side payments when nations negotiate often the toughest bargaining is not between nations but within them the reason is simple proposed international agreements no matter how much in the national interest inevitably have differential effects on factional concerns threatening to make winners of some and losers of others potential losers often have the power to prevent agreements not to their liking thereby limiting what is possible in international negotiations this article uses a negotiation analytic framework to analyze the consequences of such limits it argues that limits need not be a liability for a divided country under some circumstances they may provide a bargaining advantage and demonstrates circumstances under which intracountry differences are desirable and undesirable from a national perspective more specifically the article shows that the effect of domestic differences on international negotiations depends on the configuration of domestic interests on the nature of domestic political processes and on characteristics of the international bargain it then explores a particular dimension of the domestic process the ability to link issues which allow factions to make internal side payments it demonstrates that internal issue linkage can have profound effects on the external bargain and explores the strategic implications of side payments for those who would manage domestic differences in international negotiations

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

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

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

patently misleading partial implementation and bargaining leverage in sino american negotiations on intellectual property rights we develop a model of international negotiation in which states antici pate that the agreements they sign will only be partly implemented the results dif fer significantly from theories of domestic ratification that have previously been applied to this problem negotiators do not try to satisfy the implementer and may even choose agreements that the implementer would explicitly reject in a ratification model par tial implementation also makes it possible for two negotiators to reach agreements outside their usual win set this situation may allow one country to make extra ordinary concessions knowing that some provisions will never be fully imple mented we apply these claims to sino american negotiations over intellectual property rights where implementation has been a recurrent issue the theory enriches the theory of two level games which has focused much too narrowly on formal rati fication without amendment as the canonical case of domestic influence over inter national bargaining

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

delegation ratification and u s trade policy why divided government causes lower tariffs recent research on executive legislative relations concludes that divided government causes higher tariffs and inhibits international cooperation i find that divided government leads to lower u s

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

domestic opposition and signaling in international crises this article explores the effect of domestic political competition on the escalation of international crises it combines an incomplete information model of crisis bargaining with a simple model of two party electoral choice one state has two strategic actors a government and an opposition party both of which declare openly whether they support the use of force to alter the status quo the rival state updates its beliefs and selects its strategy in response to both signals the parties payoffs depend upon a retrospective evaluation by the domestic electorate the model shows that the inclusion of a strategic opposition party decreases the ex ante probability of war by helping to reveal information about the state s preferences this finding has important implications for research on democracy and international conflict since it suggests a mechanism through which democratic states can overcome informational asymmetries which have been identified as a central obstacle to negotiation

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

replication realism and robustness analyzing political regimes and international trade makers who formulate trade policy we show that dai fails to accurately replicate our model and hence erroneously claims that the new equilibria she deduces are consistent with it in addition we demonstrate that in altering one of our assumptions dai offers a model that is less realistic as well as inconsistent with the substantive literature on international bargaining finally we question the robustness of her approach due to these problems of replication realism and robustness we conclude that dai s model is of limited utility ur article established that pairs of democracies trade more freely than mixed country pairs composed of a democracy and an autocracy mansfield milner and rosendorff 2000 hereafter mmr xinyuan dai 2002 asserts that our conclusion depends on the preferences of the decision makers who formulate trade policy dai is incorrect her results differ from ours solely because she has changed a key assumption of the model given the stated assumptions of our model each player s behavior in equilibrium is optimal and is a best reply it is often useful to debate the merits of a model s assumptions and it is not surprising that altering the assumptions can affect a model s results dai however ignores one of our explicitly stated assumptions and fails to acknowledge that her results differ from ours as a consequence moreover she never touches upon the relative merits of her assumption but when choosing a modeling strategy it is important to be attentive to the assumptions one uses preferring those that are more realistic and result in more general conclusions dai s model suffers from serious problems in this regard particularly because of its unrealistic assumptions about international economic negotiations furthermore dai offers no evidence about the robustness of her claims in contrast to our model finally the empirical record lends greater support to our argument than dai s since we found strong evidence that democratic pairs have had more open trade relations than mixed pairs irrespective of policy makers preferences in the following sections we elaborate on these problems of replication realism and robustness first we show that dai fails to replicate our model faithfully and hence erroneously claims that the new equilibria she deduces are consistent with it second we show that altering our assumption as dai does yields a model that is less realistic and less consistent with the substantive literature on international bargaining third we question the robustness of her approach we conclude that her model is of limited utility not only does our model capture an important element of international economic negotiations missing in dai s approach but also it yields results that are robust and have empirical support

a theory of misgovernance this paper tries to explain why government bureaucracies are often associated with red tape corruption and lack of incentives the paper identifies two specific ingredients that together can provide an explanation the fact that governments often act precisely in situations where markets fail and the presence of agency problems within the government we show that these problems are exacerbated at low levels of development and in bureaucracies dealing with poor people we also argue that we need to posit the existence of a welfare oriented constituency within the government in order to explain red tape and corruption

domestic institutions and international bargaining the role of agent veto in two level games putnam s 1988 conjecture that negotiators can benefit from their domestic constraints implies that they may want to impose domestic constraints on themselves by granting veto power to an agent i show that a negotiator s decision to employ an agent as veto player depends on the kinds of information available to the foreign country and the alignment of preferences between the negotiator and the agent when the foreign country has incomplete information about the negotiator s preferences and the negotiator has preferences too divergent from those of the agent the negotiator will not give veto power to the agent however this applies only to an agent with extreme preferences and a surprisingly large number of agent types will receive veto power the attractiveness of the agent veto to the negotiator is in part due to its informational effect by granting veto power to an agent the negotiator can transmit more information to the foreign country and capture informational gains that would be lost in the absence of the agent veto

how corruption may corrupt abstract the incidence of corruption appears to vary strongly across societies even for comparable activities the model highlights how the profitability of bureaucratic corruption may be related to its frequency and points toward a few mechanisms that can be used in explaining the stylized facts of varying incidence of corruption there might be multiple self fulfilling equilibria levels of corruption even when both supply and demand of corrupt acts are considered

from unanimity to consensus an analysis of the negotiations at the eu s constitutional convention disputes filed at the world trade organization wto are attracting a growing number of third parties most observers argue that their participation influences the institution s rulings the authors argue that third parties undermine pretrial negotiations their influence on rulings is conditioned by this selection effect they test their hypotheses along with the conventional wisdom using a data set of wto disputes initiated through 2002 consistent with the authors argument they find that third party participation lowers the prospects for early settlement controlling for this selection effect the evidence also suggests that third party support increases the chances of a legal victory at the wto

red tape and corruption abstract we study the emergence and interaction of red tape and corruption in a principal bureaucrat agent hierarchy the principal is to provide the agent with a unit of a good that involves externalities so that market mechanisms fail to achieve first best red tape produces information but is costly to the agent and is administered by a corrupt bureaucrat first the bureaucrat may extort bribes from the agent in exchange for reducing the amount of red tape second the bureaucrat may take bribes to conceal the information produced through red tape even though the former kind of corruption tends to reduce red tape we show that the equilibrium level of red tape is above the social optimum

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

corruption extortion and evasion corruption evasion and the abuse of power and the possibility thereof are pervasive features of economic activity a prominent instance is tax collection this paper examines the implications of corruptibility and the potential abuse of authority for the effects and optimal design of potentially non linear tax collection schemes amongst the findings are that the distributional effects of evasion and corruption are unambiguously regressive under the kinds of schemes usual in practice and collecting progressive taxes without inducing evasion or corruption may require that inspectors be paid commission on high income reports but not on low with the cost of this potentially creating what seems to be a previously unnoticed trade off between equity and efficiency

performance based wages in tax collection the brazilian tax collection reform and its effects we use panel data from the brazilian tax collection authority to examine the effects of a major incentive reform instituted in 1989 to improve tax enforcement beforehand fine collections per inspection were relatively stable however a striking trend break occurred afterwards which we attribute to the incentive reform not to changes in the macroeconomy or personal and corporate income tax rates our estimates suggest the growth in fines per inspection after the reform is about 75 above what it would have been without it and that there is substantial heterogeneity in the impact of the reform across tax regions

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

uncertainty and ratification failure i study a game where two agents bargain on an agreement to replace the status quo for their agreement to come into effect they need the approval of a third agent the preferences of this third agent is private information but there is communication among agents i study this game in the context of international agreements to provide an explanation for involuntary ratification failures i show that under certain assumptions the informational deficiency is incurable due to incentives to misrepresent preferences and that a parliament whose majority is more hawkish than their executive prefers the executive to be risk averse

the statistical and economic role of jumps in continuous time interest rate models this paper analyzes the role of jumps in continuous time short rate models i first develop a test to detect jump induced misspecification and using treasury bill rates find evidence for the presence of jumps second i specify and estimate a nonparametric jump diffusion model results indicate that jumps play an important statistical role estimates of jump times and sizes indicate that unexpected news about the macroeconomy generates the jumps finally i investigate the pricing implications of jumps jumps generally have a minor impact on yields but they are important for pricing interest rate options

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

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