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Journal Article
Formulating the imputed cost of equity capital for priced services at Federal Reserve banks
This paper was presented at the conference "Economic Statistics: New Needs for the Twenty-First Century," cosponsored by the Federal Reserve Bank of New York, the Conference on Research in Income and Wealth, and the National Association for Business Economics, July 11, 2002. According to the 1980 Monetary Control Act, the Federal Reserve Banks must establish fees for their priced services to recover all operating costs as well as the imputed costs of capital and taxes that would be incurred by a profit-making firm. Since 2002, the Federal Reserve has made fundamental changes to the ...
Discussion Paper
Did the Fed’s Term Auction Facility Work?
The Federal Reserve introduced the Term Auction Facility (TAF) in December 2007 to provide term loans to banks during the recent financial crisis. In this post, we report on the effectiveness of the TAF during the early stages of the crisis. We find that the TAF was associated with a decrease in the “liquidity premium,” one component of a bank’s borrowing cost. In other words, the TAF worked as intended.
Report
Assessing the impact of short-sale constraints on the gains from international diversification
This paper examines the impact of short-sale constraints on the magnitude of international diversification benefit for U.S. investors during the period of 1976?1998. The diversification benefit is measured as the increase in expected return when switching from the U.S. equity index portfolio to the efficient international portfolio with equal variance. Although short-sale constraints reduce the diversification benefit, we find that the reduction caused by the constraints on emerging markets is small. This result holds in both pre- and post-liberalization periods. They are also unaffected by ...
Report
Performance maximization of actively managed funds
Ratios that indicate the statistical significance of a fund's alpha typically appraise its performance. A growing literature suggests that even in the absence of any ability to predict returns, holding options positions on the benchmark assets or trading frequently can significantly enhance performance ratios. This paper derives the performance-maximizing strategy--a variant of buy-write--and the least upper bound on such performance enhancement, thereby showing that if common equity indexes are used as benchmarks, the potential performance enhancement from trading frequently is usually ...
Report
The effect of the Term Auction Facility on the London inter-bank offered rate
The Term Auction Facility (TAF), the first auction-based liquidity initiative by the Federal Reserve during the global financial crisis, was aimed at improving conditions in the dollar money market and bringing down the significantly elevated London interbank offered rate (Libor). The effectiveness of this innovative policy tool is crucial for understanding the role of the central bank in financial stability, but academic studies disagree on the empirical evidence of the TAF effect on Libor. We show that the disagreement arises from misspecifications of econometric models. Regressions using ...
Report
Design of contingent capital with a stock price trigger for mandatory conversion
Contingent capital (CC), a regulatory debt that must convert into common equity when a bank?s equity value falls below a specified threshold (a trigger), does not in general lead to a unique equilibrium in the prices of the bank?s equity and CC. Multiplicity or absence of equilibrium arises because economic agents are not allowed to choose a conversion policy in their best interests. The lack of unique equilibrium introduces the potential for price manipulation, market uncertainty, inefficient capital allocation, and unreliability of conversion. Because CC may not convert to equity in a ...
Report
Y2K options and the liquidity premium in Treasury bond markets
Financial institutions around the world expected the millennium date change (Y2K) to cause an aggregate liquidity shortage. Responding to concerns about this liquidity shortage, the Federal Reserve Bank of New York auctioned Y2K options to primary dealers. The options gave the dealers the right to borrow from the Fed at a predetermined interest rate. The implied volatilities of Y2K options and the aggressiveness of demand for these instruments reveal that the Fed's action eased the fears of bond dealers, contributing to a drop in the liquidity premium of Treasury securities. Our analysis ...
Report
Empirical evaluation of asset pricing models: arbitrage and pricing errors over contingent claims
In a 1997 paper, Hansen and Jagannathan develop two pricing error measures for asset pricing models. The first measure is the maximum pricing error on given test assets, and the second measure is the maximum pricing error over all possible contingent claims. We develop a simulation-based Bayesian inference of the pricing error measures. Although linear time-varying and multifactor models are widely reported to have small pricing errors on standard test assets, we demonstrate that these models can have large pricing errors over contingent claims because their stochastic discount factors are ...
Report
Arbitrage pricing theory
Focusing on capital asset returns governed by a factor structure, the Arbitrage Pricing Theory (APT) is a one-period model, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The APT, however, does not preclude arbitrage over dynamic portfolios. Consequently, applying the model to evaluate managed portfolios is contradictory to the no-arbitrage spirit of the model. An empirical test of the APT entails a procedure to identify features of the underlying factor structure rather than ...
Report
Valuing the Treasury's Capital Assistance Program
The Capital Assistance Program (CAP) was created by the U.S. government in February 2009 to provide backup capital to large financial institutions unable to raise sufficient capital from private investors. Under the terms of the CAP, a participating bank receives contingent capital by issuing preferred shares to the Treasury combined with embedded options for both parties: the bank gets the option to redeem the shares or convert them to common equity, with conversion mandatory after seven years; the Treasury earns dividends on the preferred shares and gets warrants on the bank's common ...