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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 ...
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
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 ...
Working Paper
Bank procyclicality, credit crunches, and asymmetric monetary policy effects: a unifying model
Much concern has recently been expressed that both large, procyclical changes in bank assets and "credit crunches" caused by bank reluctance to expand loans during recessions contribute to economic instability. These effects are difficult to explain using the standard textbook model of deposit expansion in which deposits are constrained only by reserve requirements. However, these effects follow easily if the model is expanded to include a second, capital constraint.
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
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
Market discipline and subordinated debt: a review of some salient issues
Requiring banks to issue subordinated debt is one proposal to bring market discipline to bear in aiding regulatory supervision. This article explores the frictions that produce a need for discipline (agency problems) and the mechanisms markets have evolved for dealing with these frictions. Following an examination of the rationales and assumptions underlying subordinated debt proposals, the article concludes that the case tying regulatory intervention to subordinated debt spreads is not clear-cut, and that use of all available information, including equity returns and debt yields, when ...
Journal Article
Derivatives clearing and settlement: a comparison of central counterparties and alternative structures
Most exchange-traded and some over-the-counter (OTC) derivatives are cleared and settled through clearinghouses that function as central counterparties (CCPs). Most OTC derivatives are settled bilaterally. This article discusses how these alternative mechanisms affect the functioning of derivatives markets and describes some of the advantages and disadvantages of each.