Search Results
Working Paper
Callable U.S. Treasury bonds: optimal calls, anomalies, and implied volatilities
Previous studies on interest rate derivatives have been limited by the relatively short history of most traded derivative securities. The prices for callable U.S. Treasury securities, available for the period 1926?95, provide the sole source of evidence concerning the implied volatility of interest rates over this extended period. Using the prices of callable, as well as non-callable, Treasury instruments, this paper estimates implied interest rate volatilities for the past seventy years. Our technique for estimating implied volatilities enables us to address two important issues concerning ...
Working Paper
Empirical tests of two state-variable HJM models
Models for pricing interest rate claims, developed under the Heath-Jarrow-Morton paradigm, differ according to the volatility structure imposed on forward rates. For most general HJM structures the resultant path dependence creates implementation problems. Ritchken and Sankarasubramanian have recently identified necessary and sufficient conditions on the class of volatility structures of forward rates that enable the term structure dynamics to be captured by a finite set of state variables. The class is quite rich. The instantaneous spot rate volatility may be quite general, but the model ...
Journal Article
Movements in the term structure of interest rates
Bond prices tend to move together. Stocks tend to go their own way. This distinction requires completely different approaches to managing risks for these securities. For equities the emphasis is on reducing idiosyncratic risk through portfolio diversification. For interest rate-sensitive securities it is on precisely balancing a portfolio to achieve the desired exposure to systematic risk factors. ; Hedging to reduce or eliminate the common factors influencing an interest rate-sensitive portfolio's value requires a model of interest rate behavior. This article reviews and extends previous ...
Working Paper
Netting, financial contracts, and banks: the economic implications
Derivatives and certain other off-balance sheet contracts enjoy special legal protection on insolvent counterparties through a process referred to as 'close-out netting.' This paper explores the legal status and economic implications of this protection. While this protection benefits major derivatives dealers and derivatives markets, it is less clear that other market participants or markets in general are better or worse off. While we are not able to conclude whether or not these protections are socially optimal, we outline the wide range of issues that a general consideration of the pros ...
Newsletter
Common sense about executive stock options
Working Paper
The stability of interest rate processes
This paper presents a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (CKLS 1992). By redefining the possible regime shift period in line with evidence from known policy changes and past empirical research, we find evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is defined to be temporary and coincident with the Federal Reserve ...
Working Paper
The pitfalls in inferring risk from financial market data
This paper examines two qualitative rules of thumb, frequently invoked in discussions of bank regulatory policy. The first, that equity holders prefer more risk to less, derives from a result in option pricing theory, that an option's value increases monotonically with the riskiness of the underlying asset. This result is shown to depend on very restrictive assumptions regarding the underlying assets return distribution and the type of option being considered. These restrictive assumptions do not generally obtain in practice. The second rule of thumb is that bondholders' and deposit insurers' ...
Journal Article
Bankruptcy law and large complex financial organizations: a primer
Large complex financial organization (LCFOs) are exposed to multiple problems when they become insolvent. They operate in countries with different approaches to bankruptcy and, within the U.S., multiple insolvency administrators. The special financial instruments that comprise a substantial portion of LCFO assets are exempted from the usual "time out" that permits the orderly resolution of creditor claims. This situation is complicated by the opacity of LCFIs' positions, which may make them difficult to sell or unwind in times of financial crisis. This article discusses these issues and their ...
Working Paper
Resolution of large complex financial organizations
The resolution of a large complex financial organization (LCFO) presents numerous problems, including organizational complexity, opacity of positions, and conflicting legal jurisdictions. Of particular concern is the potential impact of large derivatives books. Widespread adoption of laws permitting close-out of derivatives contracts exempts these contracts from the usual stays that provide time for the orderly resolution of claims by the courts. Thus, a potentially significant part of the LCFO's assets and liabilities are exempted from normal bankruptcy procedures, creating the potential for ...