Encyclopedia of Finance

More than two-thirds of member countries of the International Monetary Fund (IMF) have experienced one or more banking crises in recent years. The inherent fragility of banks has motivated about 50 percent of the countries in the world to establish deposit insurance schemes. By increasing depositor confidence, deposit insurance has the potential to provide for a more stable banking system. Although deposit insurance increases depositor confidence, it removes depositor discipline. Banks are thus freer to engage in activities that are riskier than would otherwise be the case. Deposit insurance itself, in other words, could be the cause of a crisis. The types of schemes countries have adopted will be assessed as well as the benefits and costs of these schemes in promoting stability in the banking sector.

The Gramm-Leach-Bliley Act (GLBA) was signed into law on November 12, 1999 and essentially repealed the Glass-Steagall Act (GSA) of 1933 that had mandated the separation of commercial banking activities from securities activities. It also repealed provisions of the Bank Holding Company Act (BHCA) of 1956 that provided for the separation of commercial banking from insurance activities. The major thrust of the new law, therefore, is the establishment of a legal structure that allows for the integration of banking, securities and insurance activities within a single organization. The GLBA will be explained and discussed, with special emphasis on its importance for U.S. banks in a world of ever increasing globalization of financial services.

Coupon-prefunded bonds have been developed and sold by investment bankers in place of zero-coupon bonds to raise funds for companies facing cashflow problems. Additional bonds are issued and proceeds are deposited in an escrow account to finance the coupon payment. Our analysis indicates that a coupon-prefunded bond is equivalent to a zero-coupon bond only if the return from the escrow account is the same as the yield to maturity of the prefunded issue. In reality, the escrow return is lower than the bond yield. As a result, the firm provides interest subsidy through issuing additional bonds which leads to higher leverage, greater risk, and loss of value compared to a zero-coupon issue.

Empirical work on portfolio choice and asset pricing has shown that an investor’s current asset demand is affected by the possibility of uncertain changes in future investment opportunities. In addition, different countries have different prices for goods when there is a common numeraire in the international portfolio choice and asset pricing. In this survey, we present an intertemporal international asset pricing model (IAPM) that prices market hedging risk and exchange rate hedging risk in addition to market risk and exchange rate risk. This model allows us to explicitly separate hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as separate exchange rate risk from intertemporal hedging risk.

Credit derivatives are instruments used to measure, manage, and transfer credit risk. Recently, there has been an explosive growth in the use of these instruments in the financial markets. This article reviews the structure and use of some credit derivative instruments that are popular in practice.

This article presents a set of international parity conditions based on consistent and efficient market behavior. We hypothesize that deviations from parity conditions in international bond, stock, and commodity markets are attributable mainly to relative equity premiums and real interest rate differentials. Testing this hypothesis against four European markets for the recent floating currency period, we gain supportive evidence. Moreover, the deviations of uncovered interest parity, international stock return parity, and purchasing power parity are not independent; the evidence suggests that deviations from the three parities are driven by two common factors: equity premium differential and real interest rate differential.

In January 1997, the U.S. Treasury began to issue inflation-indexed securities (TIIS). The new Treasury security protects investors from inflation by linking the principal and coupon payments to the Consumer Price Index (CPI). This paper discusses the background of issuing TIIS and reviews their unique characteristics.

The asset pricing models of financial economics describe the prices and expected rates of return of securities based on arbitrage or equilibrium theories. These models are reviewed from an empirical perspective, emphasizing the relationships among the various models.

Conditional asset pricing studies predictability in the returns of financial assets, and the ability of asset pricing models to explain this predictability. The relation between predictability and asset pricing models is explained and the empirical evidence for predictability is summarized. Empirical tests of conditional asset pricing models are then briefly reviewed.

Measures for evaluating the performance of a mutual fund or other managed portfolio are interpreted as the difference between the average return of the fund and that of an appropriate benchmark portfolio. Traditional measures use a fixed benchmark to match the average risk of the fund. Conditional performance measures use a dynamic strategy as the benchmark, matching the fund’s risk dynamics. The logic of this approach is explained, the models are described and the empirical evidence is reviewed.

One of the everyday jobs of the treasurer is to manage the cash, and flow of funds through the organization. If the amount or receipt and collection activities are out of control, the entire firm may face bankruptcy. There is an old saying, “If you pay attention to the pennies, the dollars will take care of themselves.” In this spirit, this paper looks at taking care of the daily amounts of cash flowing through the firm in a systematic fashion. The purpose is to understand the importance of the inter-relationships involved and to be able to measure the amount and speed of the cash flow. Once something can be measured, it can be managed.

The stochastic discount factor (SDF) approach to fund performance is a recent innovation in the fund performance literature (Chen and Knez, 1996). A number of recent studies have used the stochastic discount factor approach to evaluate the performance of managed funds. In this paper, I present an overview of the use of the stochastic discount approach to evaluate the unconditional and conditional performance of the fund. I also discuss estimation issues and provide a brief survey of empirical evidence.

We discuss duration and its development, placing particular emphasis on various applications. The survey begins by introducing duration and showing how traders and portfolio managers use this measure in speculative and hedging strategies. We then turn to convexity, a complication arising from relaxing the linearity assumption in duration. Next, we present immunization — a hedging strategy based on duration. The article goes on to examine stochastic process risk and duration extensions, which address it. We then examine the track record of duration and how the measure applies to financial futures. The discussion then turns to macrohedging the entire balance sheet of a financial institution. We develop a theoretical framework for duration gaps and apply it, in turn, to banks, life insurance companies, and defined benefit pension plans.

Loan contract terms refer to the price and nonprice terms associated with a corporate loan deal between a borrower and a lender or a syndicate of lenders. The specification of loan contract terms differs across loans. These differences are attributable to the tradeoffs between values of loan contract terms that the borrower chooses when negotiating the loan contract, as well as the purpose of the loan and borrower and lending syndicate characteristics. Methodological issues that arise when investigating the relations between loan contract terms include allowing for loan contract terms that are determined simultaneously and accurately estimating credit risk.

A and B shares exist in the Chinese stock markets. A shareholders are domestic investors and B shareholders are foreign investors. During the early-and mid-1990s, B shares were traded at a discount relative to A shares, and B-share returns were higher than A-share returns. It is found that B-share market has persistent higher bid-ask spreads than the A-share market and traders in the B-share market bear higher informed trading and other transaction costs. In addition, the higher volatility of B-share returns can be attributed to the higher market making costs in the B-share market.

All NYSE-listed stocks were switched from a fractional to a decimal trading system on January 29, 2001 and all NASDAQ stocks followed suit on April 9, 2001. The conversion to decimal trading in the U.S. markets has significantly reduced bid-ask spreads. This decline is primarily due to the drop in market makers’ costs for supplying liquidity. In addition, rounding becomes less salient after the decimalization. The decrease in bid-ask spreads can be ascribed to the decrease in price rounding, when controlling for the changes in trading variables.

Several important trading rules were introduced in NASDAQ in 1997. The trading reforms have significantly reduced bid-ask spreads on NASDAQ. This decrease is due to a decrease in market-making costs and/or an increase in market competition for order flows. In addition, in the post-reform period, the spread difference between NASDAQ and the NYSE becomes insignificant with the effect of informed trading costs controlled.

Under the state corporate chartering system in the U.S., managers may seek shareholder approval to reincorporate the firm in a new state, regardless of the firm’s physical location, whenever they perceive that the corporate legal environment in the new state is better for the firm. Legal scholars continue to debate the merits of this system, with some arguing that it promotes contractual efficiency and others arguing that it often results in managerial entrenchment. We discuss the contrasting viewpoints on reincorporations and then summarize extant empirical evidence on why firms reincorporate, when they reincorporate, and where they reincorporate to. We conclude by discussing how the motives managers offer for reincorporations, and the actions they take upon reincorporating, influence how stock prices react to reincorporation decisions.

The basic rules of balancing the expected return on an investment against its contribution to portfolio risk are surveyed. The related concept of Capital Asset Pricing Model asserting that the expected return of an asset must be linearly related to the covariance of its return with the return of the market portfolio if the market is efficient and its statistical tests in terms of Arbitraging Price Theory are also surveyed. The intertemporal generalization and issues of estimation errors and portfolio choice are discussed as well.

The proliferation of the Internet has led to the rapid growth of online brokerage. As the Internet now allows individual investors access to information previously available only to institutional investors, individual investors are profiting in the financial markets through online trading schemes. Rock-bottom fees charged by the online brokers and the changing attitude toward risk of the Internet-literate generation prompt the practitioners to question the validity of the traditional valuation models and statistics-based portfolio formulation strategies. These tactics also induce more dramatic changes in the financial markets. Online trading, however, does involve a high degree of risk, and can cause a profitable portfolio to sour in a matter of minutes. This paper addresses the major challenges of trading stocks on the Internet, and recommends a decision support system for online traders to minimize the potential of risks.

This paper analytically determines the conditions under which four commonly utilized portfolio measures (the Sharpe index, the Treynor index, the Jensen alpha, and the Adjusted Jensen’s alpha) will be similar and different. If the single index CAPM model is appropriate, we prove theoretically that well-diversified portfolios must have similar rankings for the Treynor, Sharpe indices, and Adjusted Jensen’s alpha ranking. The Jensen alpha rankings will coincide if and only if the portfolios have similar betas. For multi-index CAPM models, however, the Jensen alpha will not give the same ranking as the Treynor index even for portfolios of large size and similar betas. Furthermore, the adjusted Jensen’s alpha ranking will not be identical to the Treynor index ranking.

The exposure of a number of serious financial frauds in high-performing listed companies during the past couple of years has motivated investors to move their funds to more reputable accounting firms and investment institutions. Clearly, bankruptcy, or corporate failure or insolvency, resulting in huge losses has made investors wary of the lack of transparency and the increased risk of financial loss. This article provides definitions of terms related to bankruptcy and describes common models of bankruptcy prediction that may allay the fears of investors and reduce uncertainty. In particular, it will show that a firm filing for corporate insolvency does not necessarily mean a failure to pay off its financial obligations when they mature. An appropriate risk-monitoring system, based on well-developed failure prediction models, is crucial to several parties in the investment community to ensure a sound financial future for clients and firms alike.

Even though risk management is the quality control of finance to ensure the smooth functioning of the business model and the corporate model, this chapter takes a more focused approach to risk management. We begin by describing the methods to calculate risk measures. We then describe how these risk measures may be reported. Reporting provides feedback to the identification and measurements of risks. Reporting enables the risk management to monitor the enterprise risk exposures so that the firm has a built-in, self-correcting procedure that enables the enterprise to improve and adapt to changes. In other words, risk management is concerned with four different phases, which are risk measurement, risk reporting, risk monitoring, and risk management in a narrow sense. We focus on risk measurement by taking a numerical example. We explain three different methodologies for that purpose, and examine whether the measured risk is appropriate based on observed market data.

Interest movement models are important to financial modeling because they can be used for valuing any financial instruments whose values are affected by interest rate movements. Specifically, we can classify the interest rate movement models into two categories: equilibrium models and no-arbitrage models. The equilibrium models emphasize the equilibrium concept. However, the no-arbitrage models argue that the term-structure movements should satisfy the no-arbitrage condition. The arbitrage-free interest rate model is an extension of the Black-Scholes model to value interest rate derivatives. The model valuation is assured to be consistent with the observed yield curve in valuing interest rate derivatives and providing accurate pricing of interest rate contingent claims. Therefore, it is widely used for portfolio management and other capital market activities.

In this article, the history and the success of Real Estate Investment Trusts (REITs) and Mortgage-Backed Securities (MBS) in the U.S. financial market are discussed. Both securities are derived from real estate related assets and are able to increase the liquidity on real estate investment. They also provide investors with the opportunity to diversify portfolios because real estate assets are relatively less volatile and less correlated to existing investment instruments. Therefore, REITs and MBS enhance the width and the depth of the financial market.

Experimental findings and in particular Prospect Theory and Cumulative Prospect Theory contradict Expected Utility Theory, which in turn may have a direct implication to theoretical models in finance and economics. We show growing evidence against Cumulative Prospect Theory. Moreover, even if one accepts the experimental results of Cumulative Prospect Theory, we show that most theoretical models in finance are robust. In particular, the CAPM is intact even if investors make decisions based on change of wealth, employ decision weights, and are risk-seeking in the negative domain.

Along with globalization, merger and acquisition has become not only a method of external corporate growth, but also a strategic choice of the firm enabling further strengthening of core competence. The megamergers in the last decades have also brought about structural changes in some industries, and attracted international attention. A number of motivations for merger and acquisition are proposed in the literature, mostly drawn directly from finance theory but with some inconsistencies. Interestingly, distressed firms are found to be predators and the market reaction to these is not always predictable. Several financing options are associated with takeover activity and are generally specific to the acquiring firm. Given the interest in the academic and business literature, merger and acquisition will continue to be an interesting but challenging strategy in the search for expanding corporate influence and profitability.

We explore primarily the problems encountered in multivariate normal integration and the difficulty in root-finding in the presence of unknown critical value when applying compound real call option to evaluating multistage, sequential high-tech investment decisions. We compared computing speeds and errors of three numerical integration methods. These methods, combined with appropriate root-finding method, were run by computer programs Fortran and Matlab. It is found that secant method for finding critical values combined with Lattice method and run by Fortran gave the fastest computing speed, taking only one second to perform the computation. Monte Carlo method had the slowest execution speed. It is also found that the value of real option is in reverse relation with interest rate and not necessarily positively correlated with volatility, a result different from that anticipated under the financial option theory. This is mainly because the underlying of real option is a nontraded asset, which brings divide nd-like yield into the formula of compound real options.In empirical study, we evaluate the initial public offering (IPO) price of a new DRAM chipmaker in Taiwan. The worldwide average sales price is the underlying variable and the average production cost of the new DRAM foundry is the exercise price. The twin security is defined to be a portfolio of DRAM manufacturing and packaging firms publicly listed in Taiwan stock markets. We estimate the dividend-like yield with two methods, and find the yield to be negative. The negative dividend-like yield results from the negative correlation between the newly constructed DRAM foundry and its twin security, implying the diversification advantage of a new generation of DRAM foundry with a relative low cost of investment opportunity. It has been found that there is only a 4.6 percent difference between the market IPO price and the estimated one.

Market efficiency is one of the most fundamental research topics in both economics and finance. Since Fama (1970) formally introduced the concept of market efficiency, studies have been developed at length to examine issues regarding the efficiency of various financial markets. In this chapter, we review elements, which are at the heart of market efficiency literature: the statistical efficiency market models, joint hypothesis testing problem, and three categories of testing literature.

The vast empirical failure of standard macro exchange rate determination models in explaining exchange rate movements motivates the development of microstructure approach to exchange rates in the 1990s. The microstructure approach of incorporating “order flow” in empirical models has gained considerable popularity in recent years, since its superior performance to macro exchange rate models in explaining exchange rate behavior. It is shown that order flow can explain about 60 percent of exchange rate movements versus 10percent at most in standard exchange rate empirical models. As the microstructure approach to exchange rates is an active ongoing research area, this chapter briefly discusses key concepts that constitute the approach.

Arbitrage is central to finance. The classical implications of the absence of arbitrage are derived in economies with no market frictions. A recent literature addresses the implications of no-arbitrage in settings with various market frictions. Examples of the latter include restrictions on short sales, different types of impediments to borrowing, and transactions costs. Much of this literature employs assumptions of continuous time and a continuous state space. This selected review of the literature on arbitrage and market frictions adopts a framework with discrete states. It illustrates and discusses a sample of the principal results previously obtained in continuous frameworks, clarifying the underlying intuition and enabling their accessibility to a wider audience.

This article discusses some fundamental cost-benefit tradeoffs involving publicly traded corporations from a corporate finance viewpoint. The fundamental benefits include greater access to capital at a lower cost and economies of scale. The potential costs are associated with two fundamental problems: principal-agent conflicts of interest and information asymmetry. Various mechanisms have evolved in the United States to mitigate these problems and their costs, so that the bulk of the fundamental benefits can be realized.

The Mexican Peso Crisis was the byproduct of various developments including large inflows of short-term foreign capital, prolonged current account deficit, and political instability. Between 1990 and 1993, investors in the United States were particularly eager to provide loans, many of them short-term, to the Mexican government and to Mexican corporations. Throughout this period, the share of foreign capital inflows exceeded the current account deficit. However, political instability and U.S. interest rate hikes soon changed the optimism for Mexico’s economic outlook. At the beginning of 1994, this did not affect the value of the peso, for Mexico was operating with a target zone exchange rate and its central bank stood ready to accept pesos and pay out dollars at the fixed rate. Yet Mexico’s reserves of foreign currency were too small to maintain its target zone exchange rate. When Mexico ran out of dollars at the end of 1994, the Mexican government announced a devaluation of the peso. As a r esult, investors avoided buying Mexican assets, adding to downward pressure on the peso.Overall, the Mexican meltdown of 1994–1995 had many facets. Yet couple of lessons are particularly clear: while foreign capital can make up for the shortfall in domestic saving, only long-term capital — in the forms of foreign direct investment or long-term debt — is conducive to domestic investment; large and abrupt movements of capital across national borders can cause excessive financial market volatility and undermine economic stability in the countries involved. Last and most importantly, prolonged current account deficit should be remedied by allowing the domestic currency to depreciate, promoting savings, or cutting back government expenditure rather than financed by foreign capital inflows. Countries with protracted current account deficits such as Argentina, the Philippines, Indonesia, Thailand, and Saudi Arabia, with Thailand in particular, should heed Mexico’s experience.

The portfolio performance evaluation involves the determination of how a managed portfolio has performed relative to some comparison benchmark. Performance evaluation methods generally fall into two categories, namely conventional and risk-adjusted methods. The most widely used conventional methods include benchmark comparison and style comparison. The risk-adjusted methods adjust returns in order to take account of differences in risk levels between the managed portfolio and the benchmark portfolio. The major methods are the Sharpe ratio, Treynor ratio, Jensen’s alpha, Modigliani and Modigliani, and Treynor Squared. The risk-adjusted methods are preferred to the conventional methods.

A call auction is an order driven facility which, in contrast with continuous trading, batches multiple orders together for simultaneous execution in a multilateral trade, at a single price, at a predetermined point in time, by a predetermined matching algorithm. The chapter describes how orders are handled and clearing prices set in call auction trading, contrasts call auctions with continuous trading, and identifies different types of call auctions (including price scan auctions, sealed bid auctions, and open limit order book auctions). Attention is given to the use of information technology in call market design, the integration of an auction in a market’s micro-structure, and to the facility’s ability to deal with market quality issues such as containing intra-day price volatility, sharpening price discovery, and catering to participant demands for immediacy. To produce robust results, a call auction must attract sufficient critical mass order flow; the paper concludes by noting that, bec ause large traders in particular are reluctant to enter their orders early in the auction process, book building cannot be taken for granted.

Liquidity, which is integrally related to trading costs, refers to the ability of individuals to trade at reasonable prices with reasonable speed. As such, liquidity is a major determinant, along with risk and return, of a company’s share value. Unfortunately, an operational, generally accepted measure of liquidity does not exist. This entry considers the following proxy measures: the bid—ask spread, the liquidity ratio (which relates the number or value of shares traded during a brief interval to the absolute value of the percentage price change over the interval), and the variance ratio (which relates the volatility of short-term price movements to longer-term price movements). The determinants of liquidity considered are the size of the market for a stock and market structure. The paper concludes by stressing that illiquidity increases the cost of equity capital for firms, but that trading costs can be reduced and liquidity enhanced by the institution of a superior trading system.

The primary focus of this entry is on market maker services, revenues, and costs. A market maker’s basic function is to service the public’s demand to trade with immediacy by continuously standing ready to buy shares from customers who wish to sell, and to sell shares to customers who wish to buy. Additionally, the market maker helps to stabilize prices and to facilitate a reasonably accurate price discovery. Further, a special type of market maker — a stock exchange specialist — fulfills the role of an auctioneer. The bid—ask spread is the classic source of market maker profits, while the costs of market maker operations include: order-processing, risk-bearing (the cost of carrying an unbalanced portfolio), and adverse selection (the cost of trading with a better-informed participant). The paper further considers the competitive environment that market makers operate within, and concludes with the thought that institutionalization, the advent of electronic trading, dereg ulation, and globalization of the equity markets have led to major changes in market maker operations in the recent past, and will continue to do so in the coming years.

The entry reviews essential elements of market structure — the systems, procedures, and protocols that determine how orders are handled, translated into trades, and transaction prices determined. There are various contrasting alternatives, such as order-driven and quote-driven markets; consolidated vs fragmented markets; human intervention vs electronic trading; and continuous markets vs periodic call auctions. A major objective of market design noted in the discussion is to enhance the accuracy with which prices are discovered in a dynamic, uncertain environment. Lastly, the entry points out that market structures are rapidly changing, and that much remains to be learned about how best to structure a technologically sophisticated, hybrid market that efficiently services the varied needs of diverse participants.

We analyze the Enron case to identify the risk factors that potentially led to its collapse and specific issues relating to its aggressive accounting and highlight the lessons for independent directors. In Enron, the interactions between external stimuli, strategies, corporate culture, and risk exposures possibly created an explosive situation that eventually led to its demise. Much of the post-Enron reforms have been directed towards regulating the roles and responsibilities of executive directors and auditors. However, the role of independent directors has received relatively lesser attention. Independent directors should analyze the risks of their companies and understand the pressures that arise from market conditions and firm-specific policies and incentive structures. They also need to close the information gap between executive directors and themselves. A post-Enron era also requires independent directors to change their focus. Traditionally, independent directors have to strike a difficult balance between maximizing returns and minimizing risks. Independent directors may now have to focus on the management of risks, the design and functioning of an effective corporate governance infrastructure, and the moderation of the power bases of dominant executives. Practically, they may also have to reduce the number of independent director appointments to enable them to focus more effectively on a fewer companies.

This paper introduces the agent-based modeling methodology and points out the strengths of this method over traditional analytical methods of neoclassical economics. In addition, the various design issues that will be encountered in the design of an agent-based financial market are discussed.

One major factor that led to the 1997 Southeast Asian financial crisis was the reliance of the afflicted nations on heavy borrowing from western banks. The crisis has shown the massive need for establishing a regional bond market. Given the huge foreign reserves held by Asian central banks, at present, it is crucial to create a vehicle in order to preserve Asian capital within the region.Recent progress has been made in the direction of creating regional bond markets in the areas of Asian Bond Fund (ABF) that deals in foreign currency and Asian Basket Currency (ABC) bonds that deals in local currency.The past few years have seen major improvements in the issuance of Asian government bonds. Yet, the area of corporate bonds in the region still remains clearly underdeveloped due to the lack of credit ratings at investment-grade. Addressing the issue of ratings is one of the real challenges that must be overcome before the Asian region could have a viable bond market.

Cross-border mergers and acquisitions have shown tremendous growth over time primarily due to a desire to circumvent tariffs and nontariff barriers arising from arms-length international trade and taxes; to obtain new options for financing; to access technology; and to distribute research and development costs over a broader base. Several factors put in place to moderate this growth include protecting key industries, limiting controlling interest levels, and restricting remittances of profits and dividends. This paper focuses on cross-border mergers and acquisitions, and their financial and economic (both macro and micro) underpinnings, which affect their direction and magnitude. In general terms, empirical analysis supports the fact that both a host country’s and the foreign country’s stock and bond prices are major causal factors that influence cross-border mergers and acquisitions.

Jump diffusion processes have been used in modern finance to capture discontinuous behavior in asset pricing. Various jump diffusion models are considered in this chapter. Also, the applications of jump diffusion processes on stocks, bonds, and interest rate are discussed.

In the United States, the same stock can be traded at different locations. In the case of listed stocks, each location is a node in national network called the Intermarket Trading System (ITS). Unlisted stocks also trade at different nodes on the National Association of Securities Dealers Automated Quotation (NASDAQ) network. Each node of these two networks may have rules for breaking queuing ties among competing orders. Orders may be routed on the networks according to official rules (as with ITS) or order preferencing arrangements (both networks). This paper examines the impact of priority rules on individual markets and networks. The development of the ITS and NASDAQ networks as well as the relevant literature is discussed. I conclude that network priority rules improve market quality if they result in consolidated markets.

A strategy that buys past winners and simultaneously sells past losers based on stock performance in the past 3 to 12 months is profitable in the U.S. and the European markets. This survey paper reviews the literature on the momentum strategy and the possible explanations on the momentum profitability.

This paper modifies the well-known Mundell-Fleming model by adding equilibrium credit rationing as well as imperfect asset substitutability between bonds and loans. When the representative bank’s backward-bending loan supply curve peaks at its profit-maximizing loan rate, credit rationing can be an equilibrium phenomenon, which makes credit-dependent capital investment solely dependent upon the availability of customer market credit. With credit rationing, an expansion in money and credit shifts the IS curve as well as the LM curve even in a small open economy under a regime of fixed exchange rates, and the magnitude of offset coefficient between domestic and foreign asset components of high-powered money is less than one. In contrast, if there is no credit rationing, imperfect asset substitutability between bonds and loans per se cannot generate the real effect of money in the same model.JEL classification: E51 F41

Singapore’s unique experience in macroeconomic management involves the government’s engagement in a tripartite collective bargaining and its influence on the macroeconomic policy game in wages and exchange rates in response to inflation and output volatility. The period from the mid-190 to mid-1990 features the policy game with a Nash equilibrium in the level of wages and exchange rates and a non-Nash equilibrium in wage growth and exchange rate appreciations. Based on the empirical evidence in this period, the models used in this study suggests that wage and exchange-rate policies are a pair of complements both at their levels (Nash equilibrium) and at their percentage changes (non-Nash equilibrium).

This paper purports to provide a theoretical underpinning for the problem of the Investment Company Act. The theory of the Le Chatelier Principle is well-known in thermodynamics: The system tends to adjust itself to a new equilibrium as far as possible. In capital market equilibrium, added constraints on portfolio investment on each stock can lead to inefficiency manifested in the right-shifting efficiency frontier. According to the empirical study, the potential loss can amount to millions of dollars coupled with a higher risk-free rate and greater transaction and information costs.

This paper not only provides a comparison of recent models in the valuation of mortgage-backed securities but also proposes an integrated model that addresses important issues of path-dependence, exogenous prepayment, transaction costs, mortgagors’ heterogeneity, and the housing devaluation effect.Recent research can be categorized into two frameworks: empirical and theoretical option pricing. Purely empirically derived models often consider estimation of the prepayment model and pricing of the mortgage-backed security as distinct problems, and thus preclude explanation and prediction for the price behavior of the security. Some earlier theoretical models regard mortgage-backed securities as default-free callable bonds, prohibiting the mortgagors from exercising the default (put) option, and therefore induce bias on the pricing of mortgage-backed securities. Other earlier models assume homogeneity of mortgagors and consequently fail to address important issues of premium burnout effect and the path-dependence problem.The model proposed is a two-factor model in which the housing price process is incorporated to account for the effect of mortgagor’s default and to capture the impact of housing devaluation. Default is correctly modeled in terms of its actual payoff through a guarantee to the investors of the security such that the discrepancy is eliminated by assuming mortgage securities as either default-free or unin-sured. Housing prices have been rising at unsustainable rates nation wide, especially along the coasts, suggesting a possible substantial weakening in house appreciation at some point in the future. The effect of housing devaluation is specifically modeled by considering the possibility that the mortgagor might be restrained from prepayment even if interest rates make it advantageous to refinance.Mortgagors’ heterogeneity and the separation of exogenous and endogenous prepayments are explicitly handled in the model. Heterogeneity is incorporated by introducing heterogeneous refinancing transaction costs. The inclusion of heterogeneous transaction costs not only captures premium burnout effect but also solves the path-dependence problem. Finally, the model separates exogenous prepayment from endogenous prepayment, and estimates their distinct magnitudes from observed prepayment data. This construction provides a better understanding for these two important components of prepayment behavior. The generalized method of moments is proposed and can be employed to produce appropriate parameter estimates.

The roles played by the IMF in international debt crises have long been considered controversial among both academics and policy makers. This study reviews the role of IMF bailouts in international debt crises. The literature shows that there is a statistically significant positive wealth transfer from the IMF to the international bank creditors during major event announcements. Further, the evidence indicates the existence of market informational efficiency and different pricing behavior of different groups of international bank creditors. A pertinent future research topic would be to examine whether IMF introduces the moral hazard problem into the international financial markets.