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Report
The conditional CAPM and the cross-section of expected returns
Most empirical studies of the static CAPM assume that betas remain constant over time and that the return on the value-weighted portfolio of all stocks is a proxy for the return on aggregate wealth. The general consensus is that the static CAPM is unable to explain satisfactorily the cross-section of average returns on stocks. We assume that the CAPM holds in a conditional sense, i.e., betas and the market risk premium vary over time. We include the return on human capital when measuring the return on aggregate wealth. Our specification performs well in explaining the cross-section of average ...
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 ...
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
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
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
The CAPM is alive and well
In empirical studies of the CAPM, it is commonly assumed that, (a) the return to the value-weighted portfolio of all stocks is a reasonable proxy for the return on the market portfolio of all assets in the economy, and (b) betas of assets remain constant over time. Under these assumptions, Fama and French (1992) find that the relation between average return and beta is flat. We argue that these two auxiliary assumptions are not reasonable. We demonstrate that when these assumptions are relaxed, the empirical support for the CAPM is very strong. When human capital is also included in measuring ...
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 ...
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 ...
Working Paper
The Federal Reserve banks' imputed cost of equity capital
According to the Monetary Control Act of 1980, the Federal Reserve Banks must establish fees for their priced services to recover all operating costs as well as imputed costs of capital and taxes that would be incurred by a profit-making firm. The calculations required to establish these imputed costs are referred to collectively as the Private Sector Adjustment Factor (PSAF). In this paper, we propose a new approach for calculating the cost of equity capital used in the PSAF. The proposed approach is based on a simple average of three methods as applied to a peer group of bank holding ...
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.