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Journal Article
Convex payoffs: implications for risk-taking and financial reform
Financial executive pay is a convex function of profits if recipients get a greater increment in pay when returns are high as opposed to moderate, compared with when returns are moderate as opposed to low. Convex compensation packages give financial executives incentive to adopt risky investment projects, implement highly levered capital structures, and create new risk. Financial regulators may be able to enforce changes in compensation that would attenuate these adverse effects.
Working Paper
Bubbles as payoffs at infinity
We define rational bubbles to be securities with payoffs occurring in the infinitely distant future and investigate the behavior of bubble values. We extend our analysis to a setting of uncertainty. In an infinite-horizon arbitrage-free model of asset prices, we interpret the money market account as the value of a particular bubble; a similar interpretation holds for other assets related to the state-price deflator and to payoffs on bonds maturing in the distant future. We present three applications of this characterization of bubbles.
Discussion Paper
Efficient use of current information in short-run monetary control
Working Paper
Mortgage default and mortgage valuation
We study optimal exercise by mortgage borrowers of the option to default. Also, we use an equilibrium valuation model incorporating default to show how mortgage yields and lender recovery rates on defaulted mortgages depend on initial loan-to-value ratios when borrowers default optimally. The analysis treats both the frictionless case and the case in which borrowers and/or lenders incur deadweight costs upon default. The model is calibrated using data on California mortgages. We find that the model's principal testable implication for default and mortgage pricing?that default rates and yield ...
Journal Article
Underwater mortgages
House prices have fallen approximately 30% from their peak in 2006, accompanied by a level of defaults and foreclosures without precedent in the post-World War II era. Many homeowners have mortgages with principal amounts higher than the market value of their properties. In general, though, the rational default point is below the "underwater" point where house price equals the remaining loan balance, and depends on prospects for future house price appreciation and borrower default costs.
Working Paper
Returns on illiquid assets: are they fair games?
The simplest tests of capital market efficiency are tests of the fair game model: conditional expected returns less the interest rate are equal to zero. The fair game model is thought to obtain only when markets are perfectly liquid. We show that this conjecture is false. In a model of the housing market where heterogeneous agents must search for partners in order to trade, excess returns on housing wealth are fair games if, as is appropriate, returns are defined to include shadow prices measuring illiquidity.
Working Paper
Risk aversion and stock price volatility
Researchers on variance bounds tests of stock price volatility recognized early that risk aversion can increase the volatility of prices implied by the present-value model. This finding suggests that specifying risk neutrality may induce a bias toward rejecting the present-value model insofar as real-world investors are risk averse. However, establishing that risk aversion may increase stock price volatility does not, by itself, have implications for the presence or absence of excess volatility. This is so because risk aversion also affects the upper-bound volatility measure computed from ...
Discussion Paper
Determining the monetary instrument: a diagrammatic exposition
Working Paper
Stochastic bubbles in Markov economies
Conference Paper
Liquidity and fire sales
A ?fire sale? occurs when the owner of a good offers it for sale at a price strictly below the price that some buyers would willingly pay for the good. He does so because the advantage of the quick sale made possible by the lower price outweighs the higher price that other potential buyers would pay, given the likely delay in locating these buyers in the latter case. Fire sales can occur only in illiquid markets. This paper generalizes earlier treatments of illiquid markets by assuming that the asset can be offered for sale at any time, rather than only after its owner loses his capacity to ...