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Working Paper
A fully-rational liquidity-based theory of IPO underpricing and underperformance
I present a fully-rational symmetric-information model of an IPO, and a dynamic imperfectly competitive model of trading in the IPO aftermarket. The model helps to explain IPO underpricing, underperformance, and why share allocations favor large institutional investors. In the model, underwriters need to sell a fixed number of shares at the IPO or in the aftermarket. To maximize revenue and avoid selling into the aftermarket where they can be exploited by large investors, underwriters distort share allocations towards investors with market power, and set the IPO offer price below the ...
Working Paper
Large investors: implications for equilibrium asset, returns, shock absorption, and liquidity
The growing share of financial assets that are held and managed by large institutional investors whose desired trades move asset prices is at odds with the traditional competitive assumption that investors are small and take prices as given. This paper relaxes the traditional price-taking assumption and instead presents a dynamic multiple asset model of imperfect competition in asset markets among large investors who differ in their risk aversion. The model is used to study asset price dynamics during an LTCM-like scenario in which market rumors of distressed asset sales are followed at a ...
Working Paper
Improving grid-based methods for estimating value at risk of fixed-income portfolios
Jamshidian and Zhu (1997) propose a discrete grid method for simplifying the computation of Value at Risk (VaR) for fixed-income portfolios. Their method relies on two simplifications. First, the value of fixed income instruments is modeled as depending on a small number of risk factors chosen using principal components analysis. Second, they use a discrete approximation to the distribution of the portfolio's value. We show that their method has two serious shortcomings which imply it cannot accurately estimate VaR for some fixed-income portfolios. First, risk factors chosen using principal ...
Working Paper
A rational expectations model of financial contagion
We develop a multiple asset rational expectations model of asset prices to study the determinants of financial market contagion, and to provide an explanation for the pattern of contagion during the Asian financial crisis. Our findings show that the pattern and severity of financial contagion depends on the size of markets' sensitivities to common macroeconomic risk factors. The amount of information asymmetry within a financial market also increases its susceptibility to contagion. We focus on contagion through the cross-market hedging of macroeconomic risks. Through this channel, ...
Working Paper
Nonparametric density estimation and tests of continuous time interest rate models
Nonparametric kernel density estimation has recently been used to estimate and test short-term interest rate models, but inference has been based on asymptotics. We derive finite sample properties of kernel density estimates of the ergodic distribution of the short-rate when it follows a continuous time AR(1) as in Vasicek. We find that the asymptotic distribution substantially understates finite sample bias, variance, and correlation. Also, estimator quality and bandwidth choice depend strongly on the persistence of the interest rate process and on the span of the data, but not on sampling ...
Conference Paper
The impacts of securitization on U.S. bank holding companies
Working Paper
Reach for Yield by U.S. Public Pension Funds
This paper studies whether U.S. public pension funds reach for yield by taking more investment risk in a low interest rate environment. To study funds?? risk-taking behavior, we first present a simple theoretical model relating risk-taking to the level of risk-free rates, to their underfunding, and to the fiscal condition of their state sponsors. The theory identifies two distinct channels through which interest rates and other factors may affect risk-taking: by altering plans?? funding ratios, and by changing risk premia. The theory also shows the effect of state finances on funds?? ...
Working Paper
Knightian uncertainty and interbank lending
The bursting of the housing price bubble during 2007 and 2008 was accompanied by high interbank spreads, and a partial breakdown of interbank lending. This paper theoretically models how Knightian uncertainty over banks risk exposures may have contributed to the breakdown. The paper shows: 1) the two-tier structure of the U.S. Fed Funds market makes it robust to uncertainty, but the market may nevertheless collapse ? and private incentives to restart it may be insufficient. 2) In some circumstances government bank audits and information releases about exposures that resemble a stress test can ...
Working Paper
Reach for Yield by U.S. Public Pension Funds
This paper studies whether U.S. public pension funds reach for yield by taking more investment risk in a low interest rate environment. To study funds? risk-taking behavior, we first present a simple theoretical model relating risk-taking to the level of risk-free rates, to their underfunding, and to the fiscal condition of their state sponsors. The theory identifies two distinct channels through which interest rates and other factors may affect risk-taking: by altering plans? funding ratios, and by changing risk premia. The theory also shows the effect of state finances on funds? risk-taking ...
Journal Article
Informational easing: improving credit conditions through the release of information
Economist Matthew Pritsker of the Board of Governors of the Federal Reserve System offers a theoretical view on how regulators can reduce uncertainty in the financial markets by improving the availability of information.