Working Paper Abstracts – 1986

Working Paper Abstracts – 1986

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The paper investigates the sources of interest rate movements in Italy during the 1970s. In that decade, the country experienced the highest and most variable inflation rate among the industrial nations and was affected both by external shocks and by shocks to the labor and financial markets. The paper shows that movements in inflationary expectations dominated the nominal interest rate variability. The part of variability that was not explained by expected inflation was accounted for by unanticipated changes in the terms of trade; by contrast, domestic monetary and real disturbances did not have a sizeable impact on the variability.

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This paper provides a formal model that characterizes conflicts of interest between bondholders and shareholders and that derives the perverse incentive effect of debt financing. A two person non-cooperative game is utilized. The Rational Expectation Nash Equilibrium (RENE) concept is applied to find equilibrium solutions. When the firm issues a large amount of debt, the RENE solution is shown to be Pareto Inferior and MM Proposition I fails to obtain due to failure of MM Proposition III. This paper provides two sufficient conditions to restore the MM propositions in equilibrium. The use of convertible financial instruments conjectured by Jensen and Meckling (1976) is proved to be insufficient to restore the MM propositions globally in equilibrium. The use of protective covenants similar to the Grossman and Hart’s (1982) precommitment or bonding behavior is shown to be sufficient and it is indeed in the best interest of shareholders.

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A model with endogenously arising credit markets and banks is displayed. The model economy requires both types of institutions because they serve to control capital in different, yet complementary, ways. The value of credit market securities depends upon bank control of capital which markets cannot achieve. As regulations and technology change, the decision rules and contracts change, and the financial system creates new institutions, markets and assets. Since the model is at the level of underlying preferences and technology it can be used to consider the optimality of banking regulations when the underlying technology of controlling capital shifts. We show that, whatever the merits of the original arguments for bank regulation, with technological change bank regulation may become self-justifying. That is, we show that under plausible conditions the only reason bank regulation is needed is that it currently exists. Moreover, bank regulation can cause the very bank failures it purports to prevent. Bank regulators observing the world would erroneously argue for more bank regulations, including FDIC insurance, when this is, in fact, unnecessary.

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When several investors with different risk aversions trade competitively in a capital market, the allocation of wealth fluctuates randomly between them and acts as a state variable against which each market participant will want to hedge. This hedging motive complicates the investors’ portfolio choice and the equilibrium in the capital market. Although every financial economist is aware of this difficulty, to our knowledge, this issue has never been analyzed in detail. The current paper features two investors, with the same degree of impatience, one of them being logarithmic and the other having an isoelastic utility function. They face one risky constant-return-to-scale stationary production opportunity and they can borrow and lend to and from each other. The behavior of the allocation of wealth is characterized, along with the behavior of the rate of interest and that of the security market line. The two main results are: (1) investors in equilibrium do revise their portfolios over time so that some trading takes place, (2) provided some conditions are satisfied, the allocation of wealth admits a steady-state distribution at an interior point; this is in contrast to the certainty case, where one investor in the long run holds all the wealth. The existence of trading opens the way to a theory of capital flows and market trading volume.


A simple model is constructed to analyze the effects of a “market discipline” strategy which ends de facto government insurance of legally uninsured depositors. This strategy can induce behavioral responses by bank managers and depositors which mitigate the amount of liability being shifted to uninsured depositors. Specifically, bank managers may adopt a policy of disclosing information regarding the bank’s probability of default. This policy would enable uninsured depositors to withdraw when the probability of default rose, thereby avoiding liability for the negative net worth of the failed bank.

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In this paper, it is shown that risk aversion plays a critical role in the determination of the equilibrium stock prices and their variability in a one-asset pure exchange economy. Specifically, it is argued that the variance of equilibrium stock prices is a strictly increasing convex function of the Arrow-Pratt measure of relative risk aversion, g, if g is greater than one. Furthermore, it is shown that the inequality underlying variance bounds tests can be reversed in our model with risk aversion. Therefore, it is concluded that the high volatility of stock prices relative to dividends may imply a rejection of risk neutrality rather than a failure of stock market efficiency.

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Particularly since the passage of ERISA, institutional investors have increasingly been willing to consider investments that traditionally have been considered highly speculative. Indeed, some institutional investors now routinely use options and futures, instruments that formerly were viewed as highly speculative and thus inappropriate investments. The rationale is that these instruments, although risky if viewed alone, provide, in combination with other assets, portfolios that overall are conservative (witness the writing of covered calls).

The purpose of this paper is to examine the risk and return characteris-tics of lower-grade corporate bonds. Institutional investors have frequently considered such bonds as inappropriate for a conservative portfolio. However, if diversification eliminates much of the risk of individual bonds, lower-grade bonds might have an appropriate place in a conservative portfolio. Whether they do or not depends upon their prospective risk and return characteristics. The usual starting point for judging the prospective characteristics of an investment is a detailed analysis of historical data, the subject of this paper.


When can a government borrow a dollar and never pay back any interest or principal? We call such an arrangement under perfect foresight a rational Ponzi game. We use the transversality condition facing individual agents to show that rational Ponzi games require an infinity of lenders. The horizon of individual agents is unimportant; Ponzi games cannot be ruled out by assuming that agents have infinite horizons. We point out both the basic similarity and some key differences between rational Ponzi games and asset price bubbles or fiat money. With reference to the international debt issue, the analysis implies that conditions in the borrower’s economy are irrelevant to the feasibility of rational Ponzi games; what matters is the relationship between the paths of interest rates and population and productivity growth rates in the lenders’ economy.


We analyze the impact of ongoing FDIC deposit insurance practices on how banks price risk. We show that FDIC insurance generally subsidizes risky loans, and that the subsidy increases with risk. We also show that the FDIC subsidy increases if contractually uninsured deposits are insured implicitly. Implicit insurance has the perverse effect of biasing the subsidy towards loans that represent systemic risk to the banking system and may entail a tax to loans with no systemic risk.

This analysis can help explain what appeared to be systematic underpricing of LDC loan risks, prior to the debt crisis.


Those who study consumption behavior routinely assume that labor income is stochastic and that the utility function exhibits constant relative risk aversion. No one has derived closed form solutions to this problem, however, and therefore we do not know what the resulting consumption function looks like. In this paper, a numerical technique is used to give accurate approximations to the consumption function in multiperiod models with income uncertainty. The resulting consumption function is often dramatically different than the certainty equivalence solution typically used, in which consumption is proportional to the sum of financial wealth and the present discounted value of expected future labor income. The results help explain three important empirical consumption puzzles: the excess sensitivity of consumption to transitory income, the high growth of consumption in periods of low real interest rates, and the under spending of the elderly.

In the last section of the paper, the numerical technique is applied to examples in which borrowing constraints are imposed. It is seen that future constraints, which bind only in certain states of the world, can have effects similar to those of current constraints that are binding.


The Pratt-Arrow coefficient of risk aversion, r(w), describes decision behavior of individuals under uncertainty, when small amounts of money are involved. In this paper a two-parameter measure is proposed which also takes into account the utility function’s third derivative: by thus incorporating a risk’s skewness, one receives a better approximation for amounts which are not necessarily very small.

The model provides new theoretical results and also predicts unexpected behavior under certain conditions; this permits the model’s empirical verification.


Although the Ricardian Equivalence Theorem holds under a linear estate tax schedule, it fails to hold under a nonlinear estate tax schedule. In a representative consumer economy, a temporary lump-sum tax increase reduces contemporaneous consumption. If different consumers face different marginal estate tax rates because they leave bequests of different sizes, a lump-sum tax increase redistributes resources from consumers in low marginal estate tax brackets to consumers in high marginal estate tax brackets; aggregate consumption may rise, fall, or remain unchanged. These departures from Ricardian Equivalence hold more generally under any nonlinear tax on saving, wealth or income accruing to wealth.


In the presence of uncertain lifetimes, social security has the characteristics of an annuity: a consumer pays a tax when young in exchange for receiving a social security benefit if he survives to be old. If consumers have identical ex ante mortality probabilities, then a fully funded social security system would offer a rate of return equal to the actuarially fair rate available on competitively supplied private annuities. In this case fully funded social security would be a redundant asset and would have no effect on consumption or national saving.

In this paper, consumers have different (publicly known) ex ante mortality probabilities and consequently can buy actuarially fair private annuities offering different rates of return. If the social security system does not discriminate on the basis of ex ante mortality probabilities, then the introduction of social security induces a redistribution of income from consumers with a high probability of dying young to consumers with a low probability of dying young. Under homothetic utility this redistribution reduces aggregate bequests and aggregate consumption of young consumers in the steady state; the steady state national capital stock can either increase or decrease. If consumers display at least as much risk aversion as the logarithmic utility function, then average stead) state welfare is increased by the introduction of fully funded social security.


In this paper, we derive upper bounds on call and put options which are priced via the risk-neutral valuation approach of Cox and Ross (1976) and Harrison and Kreps (1979). The upper bounds are shown to obtain across all terminal stock price distributions for which the associated equivalent martingale measures (EMM) have a common variance. Because the proposed upper bound depends only upon the variance of the EMM and not upon the entire distribution, the bound is termed “semiparametric” and must be satisfied for processes with jumps as well as diffusion components. The relation between the variance of the EMM and the empirically observable variance is derived and some illustrative empirical evidence is presented which suggests that these bounds may be of considerable practical value.

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The unbundling of’ coupon bonds into pure discount bonds made feasible patterns of dated nominal claims that were not previously attainable. Differences between the market values of coupon bonds and the spanning portfolios of pure discount bonds are consistent with a non-tax related segmentation of the bond market. In most periods, long-maturity coupon bonds selling at a premium could have been profitably unbundled. A comparison of pure discount bond prices with estimates of the respective reservation prices for investors in coupon bonds indicates that long-term time-contingent claims were generally more highly valued once unbundled. The high initial profit from bond stripping and its subsequent decline are consistent with long-run competitive supply adjustments by investment banks. Volatility differences of actual and reservation prices for pure discount bonds are insignificant.


This study develops procedures for testing announcement effects on intraday stock returns. Intraday stock returns surrounding announcements of new issues of equity and debt are examined. During the first fifteen minutes following new equity issue announcements, there is an abnormally large number of transactions, high volume, and a -1.5% average return. There is a small, but statistically significant negative average return during the hour preceding the announcements and the average return during the three hour period surrounding the announcements is between -2.3% and -3.0% depending on the measurement procedure. The size of the offering, the stated purpose of the issue and the estimated profitability of new investments do not have a significant inspect on stock returns. New debt issue announcements also do not have a significant impact on stock returns. After the issuance of new shares, there is a significant price recovery of 1.5%. This evidence is inconsistent with many theoretical rationales for the negative price impact of new equity issue announcements.


This paper develops a general equilibrium model for analyzing the interaction of corporate financial and production decisions, consumers’ behavior and government financing. We use the model to investigate how changes in income tax rates and government debt policy affect production, interest rates, and consumer welfare. We also show how changes in the different tax rates affect other tax rates in general equilibrium.

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