the relative valuation of caps and swaptions theory and empirical evidence although traded as distinct products caps and swaptions are linked by noarbitrage relations through the correlation structure of interest rates using a string market model we solve for the correlation matrix implied by swaptions and examine the relative valuation of caps and swaptions we find that swaption prices are generated by four factors and that implied correlations are lower than historical correlations long dated swaptions appear mispriced and there were major pricing distortions during the 1998 hedge fund crisis cap prices periodically deviate significantly from the no arbitrage values implied by the swaptions market the growth in interest rate swaps during the past decade has led to the creation and rapid expansion of markets for two important types of swap related derivatives interest rate caps and swaptions these over the counter derivatives are widely used by many firms to manage their interest rate risk exposure and collectively represent the largest class of fixed income options in the financial markets the international swaps and derivatives association isda estimates that the total notional amount of caps and swaptions outstanding at the end of 1997 was over 4 9 trillion which was more than 300 times the 15 billion notional of all chicago board of trade treasury note and bond futures options combined caps and swaptions are generally traded as separate products in the financial markets and the models used to value caps are typically different from those used to value swaptions furthermore most wall street firms use a piecemeal approach in calibrating their models for caps and swaptions making it difficult to evaluate whether these derivatives are fairly priced

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

beyond privatization institutional innovation and growth in china s large state owned enterprises abstract this article demonstrates that china s large state owned enterprises soes are not stagnant fossils waiting to die under economic reform policies this sector has undergone large change due to enhanced enterprise autonomy the impact of market forces rapid growth of domestic demand for upstream products strategic integration with the world economy and the state s policy to promote large businesses china s large soes are developing new institutional forms that do not neatly fit into existing patterns china is experimentally changing its institutions through a combination of central policy local initiative and interaction with international investment this presents a challenge to the transitional orthodoxy and to ideas concerning property rights in development economics there is not a universal model of property rights and government action that works best in all circumstances china s experience with the reform of large soes shows the diverse possibilities for effective industrial institutions

sulfur dioxide control by electric utilities what are the gains from trade title iv of the 1990 clean air act amendments caaa established a market for transferable sulfur dioxide so2 emission allowances among electric utilities this market offers firms facing high marginal abatement costs the opportunity to purchase the right to emit so2 from firms with lower costs and this is expected to yield cost savings compared to a command and control approach to environmental regulation this paper uses econometrically estimated marginal abatement cost functions for power plants affected by title iv of the caaa to evaluate the performance of the so2 allowance market specifically we investigate whether the much heralded fall in the cost of abating so2 compared to original estimates can be attributed to allowance trading we demonstrate that for plants that use low sulfur coal to reduce so2 emissions technical change and the fall in prices of low sulfur coal have lowered marginal abatement cost curves by over 50 percent since 1985 the flexibility to take advantage of these chan

taxes on tax exempt bonds implicit tax rates priced in the cross section of municipal bonds are approximately two to three times as high as statutory income tax rates with implicit tax rates close to 100 using retail trades and above 70 for interdealer trades these implied tax rates can be identified because a portion of secondary market municipal bond trades involves income taxes after valuing the tax payments market discount bonds which carry income tax liabilities trade at yields around 25 basis points higher than com parable municipal bonds not subject to any taxes the high sensitivities of municipal bond prices to tax rates can be traced to individual retail traders dominating dealers and other institutions the issue of how taxes affect asset prices is an important issue in finance accounting and economics in theoretical models examining the effect of taxes

shadow pricing with suboptimal policy rules abstract this paper aims to clarify different views on the validity of the little mirrlees border price rule for project evaluation in a context where the government chooses its controls suboptimally in a systematic fashion the rule is shown to be valid quite generally for small public sector projects when the government s response restores market clearing in nontradeables and foreign exchange it can be invalid in contexts of a non market clearing or b private sector projects that generate profits distributed to households in the latter case special treatment of profit effects is required along the lines described by little and mirrlees 1974

the valuation of floating rate instruments abstract a framework for valuing floating rate notes is developed to examine the effects of 1 lags in the coupon formula 2 special contractual features and 3 default risk evidence from a sample of floaters indicates they sold at significant discounts while lags in the coupon formulas and other contractual features make these notes more variable they do not account for the magnitude of the discounts we conclude that the fixed default premium in the coupon formula of a typical note is inadequate to compensate for time varying default premiums demanded by investors who treat other corporate short term paper as close substitutes

systematic variation in yield spreads for tax exempt general obligation bonds in recent years much research has centered upon whether yield differentials between bonds which differ in default risk vary systematically over the business cycle theory suggests that during a cyclical upswing the yield differential or risk premium narrows while during a downswing the differential widens the cyclical behavior of yield spreads is well documented in the corporate bond market 4 8 12 16 this effect has only recently been given attention in the tax exempt bond market 1 11 in addition the municipal bond market may be segmented if tax exempt borrowers and investors are unable to substitute between tax exempt securities of varying default risk changes in the relative supply of and demand for these classes of securities could produce systematic fluctuations in tax exempt yield differentials these effects could be produced by regulatory statutes which require that banks purchase high grade securities and the fixed nature of bond ratings

shadow prices and substitution in trade distorted economies abstract this paper derives simple and operational shadow pricing rules in a three sector three factor general equilibrium model incorporating nontraded goods under the little mirrlees method if a single simple and empirically plausible condition is satisfied the accounting ratio for land will exceed unity and those for capital and labor will lie below unity if this condition is not satisfied or cannot be verified it is still possible to fix some accounting ratios above or below unity just from knowledge of the signs of substitution patterns in consumption and factor intensity patterns in production guidelines are also derived for setting the shadow prices of nontraded goods or quota restricted imports it is shown that the alternative domestic price method generally yields less useful guidelines than the little mirrlees method

evil is the root of all money plenary talk delivered at the annual meeting of the society for economic dynamics this abstract was borrowed from another version of this item

large firms and industrial reform in former planned economies the case of china in china s industrial reform alongside the much studied dynamism of small industries there has been a simultaneous powerful growth of large scale state industry state planning has played an important role in this process through heavy protection from international competition and support for selected enterprises which it was hoped would benefit from economies of scale and scope these enterprises have undergone gradual institutional change with growing foreign investment and slow movement towards multiplant operation this process is one in which there are emerging institutions resembling the modern business corporation albeit with specific chinese features c 1996 academic press limited copyright 1996 by oxford university press

relative shadow prices and the shadow exchange rate abstract the divergent conclusions that have been reached in the literature as to the role of the shadow exchange rate in project appraisal are reconciled in this paper it is shown that the shadow exchange rate is not needed to assess the relative shadow prices of either traded or nontraded goods

project appraisal procedures and the evaluation of foreign exchange different procedures for evaluating foreign exchange have been suggested in the project appraisal manuals of unido and little and mirrlees while it is widely agreed that the manuals differ in their practical procedures there has been disagreement as to whether they are equivalent in principle using a model due to boadway we show that the manuals differ in principle the little mirrlees procedure can be given an interpretation which correctly values traded and non traded goods in project appraisal while the unido formula for the shadow exchange rate is not required when the balance of payments constraint is binding

stochastic volatilities and correlations of bond yields i develop an interest rate model with separate factors driving innovations in bond yields and their covariances it features a flexible and tractable affine structure for bond covariances maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid ask spread furthermore market prices of interest rate caps do not deviate significantly from their no arbitrage values implied by the swaptions under the model these findings support the conjectures of collin dufresne and goldstein 2003 dai and singleton 2003 and jagnnathan kaplin and sun 2003

relative risk in municipal and corporate debt the yields of municipal bonds and corporate bonds are often compared the ratios of municipal bond yields to corporate bond yields are thought by many to be indicative of the marginal tax bracket of the marginal holder of the bonds if for example the ratio is 60 the implication is that an investor in the fortypercent tax bracket will be indifferent between the fully taxed corporate and the fully tax exempt municipal this assumes that the two bonds are currently selling at par such comparisons have attracted increased attention since the publication of merton miller s seminal debt and taxes in this work miller indirectly suggests that the marginal tax bracket at work across tax exempt and taxable bonds is equal to the corporate tax rate while the ratio of yields seems to indicate that this is true for short term bonds the yields of long term taxexempts seem too high relative to long term taxables to confirm miller s hypothesis implicit in these comparisons and the conclusions drawn from them is the tenuous notion that the compared bonds are identical except for the taxability of the coupon for example some authors have questioned whether municipals and corporates are equally risky see trzcinka 1982 the purpose of this paper is to present preliminary evidence on the relative riskiness of the two classes of bonds

the impact of business group affiliation on performance evidence from china s national champions an important aspect of china s economic reforms has been an ambitious policy to develop 100 or so large internationally competitive business groups very little is known about these national champion groups or the benefits to subsidiary firms of belonging to them this study building from insights and methods used in existing literature examines the performance of subsidiaries affiliated to china s national champion groups our results find that they perform comparatively well we discuss possible reasons for this finding and comment more generally on the important role that business groups now play in china s reform and development

auction failures and the market for auction rate securities abstract the market for auction rate securities ars made headlines during the second week of february 2008 when auctions at which the bonds interest rates reset experienced a wave of failures contrary to headlines that attribute the failures to a frozen market or investors irrationality we find that 1 even at their height less than 50 of ars experienced auction failures 2 the likelihood of auction failure was directly related to the level of the bonds maximum auction rates 3 the implied market clearing yields of bonds with failed auctions were significantly above their maximum auction rates and 4 ars yields were generally higher than yields of various cash equivalent investment alternatives we infer that investors priced the possibility of auctions failures into ars yields and rationally declined to bid for bonds for which required market yields exceeded their maximum auction rates

municipal debt and marginal tax rates is there a tax premium in asset prices we study the marginal tax rate incorporated into short term municipal rates using municipal swap market data using an affine model we identify the marginal tax rate and the credit liquidity spread in 1 week tax exempt rates as well as their associated risk premia the marginal tax rate averages 38 0 and is related to stock bond and commodity returns the tax risk premium is negative consistent with the strong countercyclical nature of after tax fixed income cash flows these results demonstrate that tax risk is a systematic asset pricing factor and help resolve the muni bond puzzle

dealer intermediation and price behavior in the aftermarket for new bond issues municipal bonds trade in decentralized broker dealer markets and are underpriced when issued but unlike equities the average price rises slowly over several days newly issued municipal bonds have high levels of price dispersion and the average price rises because the mix of trade sizes changes over time while large trades occur close to the reoffering price small trades occur between the reoffering price to as much as 5 above the reoffering price using a mixed distribution model we quantify the losses uninformed traders or issuers give up to broker dealers

is the state led industrial restructuring effective in transition china evidence from the steel sector during the reform era the chinese government has been carrying out strategic industrial policies modelled on those in post war japan and south korea in the hope of transforming its highly fragmented manufacturing sector into one that comprises a small number of internationally competitive big businesses using the evolution of the chinese steel industry structure from the late 1980s to the early 2000s as a case in point this paper finds that the chinese government s consolidation attempts have by and large not been very successful the disappointing policy outcome is interpreted by a detailed examination of the industry policy mechanism in china it is concluded that the institutional framework of the chinese state differs from its counterparts in korea and japan in some fundamental aspects among these the fragmented and uncoordinated chinese bureaucracy contributes significantly to the inefficacy of policy implementation

project appraisal procedures and the evaluation of foreign exchange a comment in 1986 dinwiddy and teal analyzed the shadow exchange rate ser in a tariff distorted small economy containing two traded and one non traded good contrary to their claim i maintain a ser is inherent to their model even if the balance of payments constraint is binding it equals the value of the marginal consumption basket at market prices divided by its value at world or foreign exchange equivalent fee prices shadow prices defined in welfare terms equal the products of the ser and 1 the world or fee prices of goods or 2 marginal products of factors at world prices copyright 1990 by the london school of economics and political science

portfolio choice with illiquid assets we present a model of optimal allocation to liquid and illiquid assets where illiquidity risk results from the restriction that an asset cannot be traded for intervals of uncertain duration illiquidity risk leads to increased and state dependent risk aversion and reduces the allocation to both liquid and illiquid risky assets uncertainty about the length of the illiquidity interval as opposed to a deterministic nontrading interval is a primary determinant of the cost of illiquidity we allow market liquidity to vary from normal periods when all assets are fully liquid to illiquidity crises when some assets can only be traded infrequently the possibility of a liquidity crisis leads to limited arbitrage in normal times investors are willing to forgo 2 of their wealth to hedge against illiquidity crises occurring once every 10 years this paper was accepted by itay goldstein finance

option theory and floating rate securities with a comparison of adjustable and fixed rate mortgages this article demonstrates how to value floating rate securities in particular adjustable rate mortgages in the presence of default the problem is not a straightforward one since endogenous termination default and prepayment necessitates solution by backward procedures but caps on the floating rate then create path dependencies the solution is to introduce an artificial state variable the past contract rate in addition to the natural stochastic variables the interest and the house price process with this technique a numerical investigation of the properties of defaultable adjustable rate mortgages is provided in all cases a comparison is made with standard fixed rate mortgages coauthors are donald c keenan walter j muller iii and james f epperson copyright 1993 by university of chicago press

default risk cannot explain the muni puzzle evidence from municipal bonds that are secured by u s treasury obligations fama 1977 and miller 1977 predict that one minus the corporate tax rate will equate after tax yields from comparable taxable and tax exempt bonds empirical evidence shows that long term tax exempt yields are higher than theory predicts two popular explanations for this empirical puzzle are that relative to taxable bonds municipal bonds bear more default risk and include costly call options i study u s government secured municipal bond yields which are effectively default free and nonmalleable these municipal yields display the same tendency to be too high i conclude that differential default risk and call options do not explain the municipal bond puzzle article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

liquidity backstops and dynamic debt runs liquidity backstops can mitigate runs in this paper we develop a dynamic model of debt runs based on he and xiong 2012 to identify both conceptually and quantitatively the value of a liquidity backstop for its run mitigating role for the purpose of identification we focus on the municipal bond markets for variable rate demand obligations and auction rate securities based on the run episodes in these markets during the financial crisis of 2007 09 and the calibrated model we find that the value of a liquidity backstop is about 14 5 basis points per annum our findings have important policy implications regarding the effectiveness of liquidity backstops in ameliorating problems of financial instability

a simple model of the taxable and tax exempt yield curves i examine the anomalous behavior of the taxable and tax exempt yield curves long municipal yields appear too high relative to the equivalent after tax yield that can be earned in treasury or corporate bonds i discuss existing explanations of the problem and propose a simple model that relates the yields of taxable bonds to the yield curve for par tax exempts the ratio of the tax exempt yield to the taxable yield increases with maturity in the model so it is consistent with observed phenomena such as inverted yield curves for taxables and contemporaneous rising yield curves for tax exempts statistical and descriptive comparisons between the yields predicted by the model and observed yields on par bonds that the model has some promise in explaining the apparent anomalies in the behaviors of the two yield curves article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies