Implied risk aversion estimates reported in the literature are strongly U-shaped. This article explores different potential explanations for these “smile” patterns: (i) preference aggregation, both with and without stochastic volatility and jumps in returns, (ii) misestimation of investors’ beliefs caused by stochastic volatility, jumps, or a Peso problem, and (iii) heterogeneous beliefs. The results reveal that preference aggregation and misestimation of investors’ beliefs caused by stochastic volatility and jumps are unlikely to be the explanation for the smile. Although a Peso problem can account for the smile, the required probability of a market crash is unrealistically large. Heterogeneous beliefs cause sizable distortions in implied risk aversion, but the degree of heterogeneity required to explain the smile is implausibly large.
This paper studies a centralized market with idiosyncratic uncertainty and money as a medium of exchange from a theoretical as well as an experimental perspective. In our model, prices are fixed and markets are cleared by rationing. We prove the existence of stationary monetary equilibria and of an optimum quantity of money. The rational solution of our model, which is based on the assumption of individual rationality and rational expectations, is compared with actual behavior in a laboratory experiment. The theoretical results are strongly supported by this experiment.
We present results from the first large-scale international survey on time discounting, conducted in 45 countries. Cross-country varia- tion cannot simply be explained by economic variables such as interest rates or inflation. In particular, we find strong evidence for cultural differences, as measured by the Hofstede cultural dimensions. For ex- ample, high levels of Uncertainty Avoidance or Individualism are both associated with strong hyperbolic discounting. Moreover, as applica- tion of our data, we find evidence for an impact of time preferences on the capability of technological innovations in a country and on environmental protection.
This article examines the recent regulatory developments with regard to short selling. Short selling regulation is an important factor in firm governance because it affects the way in which firms are subject to market discipline. As the financial crisis has attracted regulators’ notice to short selling once again, it is important to understand the fundamental legal and economic arguments regarding short selling. These arguments have at their core the question of whether there exists a market failure. The available evidence on balance suggests that short selling restrictions hamper the price discovery process. Also, while regulations against market abuse are required, it is often an ineffective detour to pursue the goal of fair markets through the regulation of short selling. On the basis of these arguments, the article evaluates the approaches taken by the US and UK regulators, who play a leading part in the current movement towards more comprehensive short selling regulation. The US Securities and Exchange Commission's (SEC's) recently adopted rules do not seem to bring much added value and will presumably affect market efficiency in the negative. First principles suggest a somewhat more positive stance on the SEC's proposal for a circuit breaker rule and the UK. Financial Services Authority's proposed disclosure approach, though both are subject to caveats. We also highlight some central questions for future research.
This article examines how firms facing volatile input prices and holding some degree of market power in their product market link their risk management and their production or pricing strategies. This issue is relevant in many industries ranging from manufacturing to energy retailing, where firms rendered "risk averse" by financial frictions decide on and commit to their hedging strategies before their product market strategies. We find that commitment to hedging modifies the pricing and production strategies of firms. This strategic effect is channelled through the risk-adjusted expected cost, i.e., the expected marginal cost under the probability measure induced by shareholders’ "risk aversion". It has opposite effects depending on the nature of product market competition: commitment to hedging toughens quantity competition while it softens price competition. Finally, not commiting to the hedging position can never be an equilibrium outcome: committing is always a best response to non committing. In the Hotelling model, committing is a dominant strategy for all firms.
We propose a novel time-changed Lévy LIBOR (London Interbank Offered Rate) market model for jointly pricing of caps and swaptions. The time changes are split into three components. The first component allows matching the volatility term structure, the second generates stochastic volatility, and the third accommodates for stochastic skew. The parsimonious model is flexible enough to accommodate the behavior of both caps and swaptions. For the joint estimation we use a comprehensive data set spanning the financial crisis of 2007–2010. We find that, even during this period, neither market is as fragmented as suggested by the previous literature.
Regulators dedicate much attention to a financial institution’s option to default, i.e. the option that distressed financial institutions have to transfer losses to their creditors. It is generally recognized that the existence of this option provides intermediaries with a powerful incentive to keep firm capital close to the minimal requirement. We argue, however, that undercapitalization harms profitable growth opportunities, i.e. the institution’s franchise value. Indeed, the capitalization of a financial institution will be ultimately driven by the net impact of capital levels on the default option and the franchise value. By considering the impact of the default option, our work complements and extends, within a simple Black-Scholes framework, the model used by Froot and Stein (1998) in the context of banks and by Froot (2007) in the context of insurance.
