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"LeRoy, Stephen F"
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Infinite Portfolio Strategies
In continuous-time stochastic calculus a limit in probability is used to extend the definition of the stochastic integral to the case where the integrand is not square-integrable at the endpoint of the time interval under consideration. When the extension is applied to portfolio strategies, absence of arbitrage in finite portfolio strategies is consistent with existence of arbitrage in infinite portfolio strategies. The doubling strategy is the most common example. We argue that this extension may or may not make economic sense, depending on whether or not one thinks that valuation should be continuous. We propose an alternative extension of the definition of the stochastic integral under which valuation is continuous and absence of arbitrage is preserved. The extension involves appending a date and state called to the payoff index set and altering the definition of convergence under which gains on infinite portfolio strategies are defined as limits of gains on finite portfolio strategies. [PUBLICATION ABSTRACT
Journal Article
Deposit insurance and the coexistence of commercial and shadow banks
We investigate how deposit insurance affects the structure of the financial system in a general equilibrium setting in which a government insurer guarantees deposits at commercial banks, but not at shadow banks. With deposit-based or risky-asset-based insurance premia, price distortions induced by subsidized deposit insurance benefit shadow banks, by allowing these banks to trade to their advantage. Insured commercial banks and uninsured shadow banks coexist under subsidized deposit insurance. Capital requirements on commercial banks make shadow banking more attractive. The asset price distortion is eliminated when the aggregate subsidy to unsuccessful commercial banks equals the aggregate penalty to successful banks.
Journal Article
IMPLEMENTATION NEUTRALITY AND TREATMENT EVALUATION
Statisticians have proposed formal techniques for evaluation of treatments, often in the context of models that do not explicitly specify how treatments are generated. Under such procedures they run the risk of attributing causation in settings where the implementation neutrality condition required for causal interpretation of parameter estimates is not satisfied. When treatment assignments are explicitly modelled, as economists recommend, these issues can be formally analysed, and the existence (or lack thereof) of implementation neutrality, and therefore quantifiable causation, can be determined. Examples are given.
Journal Article
Implementation-Neutral Causation in Structural Models
Analysts associated with the Cowles Commission attached great importance to the distinction between structural and reduced-form models: in their view structural models, but not reduced-form models, allow the analysis of causal relations. They did not present clear justification for this view. Here we show that this insight is correct, and make the demonstration of it precise. Causal relations are shown to depend on parameter restrictions that are explicit in the structural form, but not in the reduced form when the coefficients are interpreted as unrestricted constants. The requisite parameter restrictions are those associated with implementation-neutral causation. A graphical procedure is outlined that identifies causal orderings and also the ordering based on implementation-neutral causation. The same procedure applied to reduced form models produces the implementation neutral causal ordering only if the parameter restrictions are explicitly incorporated in the reduced form. The analysis is applied in investigating the validity of the causal Markov condition.
Journal Article
IMPLEMENTATION-NEUTRAL CAUSATION
The most basic question one can ask of a model is ‘What is the effect on variable y2 of variable y1?’ Causation is ‘implementation neutral’ when all interventions on external variables that lead to a given change in y1 have the same effect on y2, so that the effect of y1 on y2 is defined unambiguously. Familiar ideas of causal analysis do not apply when causation is implementation neutral. For example, a cause variable cannot be linked to an effect variable by both a direct path and a distinct indirect path. Discussion of empirical aspects of implementation neutrality leads to further unexpected results, such as that if one variable causes another the coefficient representing that causal link is always identified.
Journal Article
Rational Exuberance
This article reviews the theory of speculative bubbles. Bubbles are a promising candidate as an explanation for the stock price run-up and collapse of the 1990s in the United States. The theory considers both irrational and rational bubbles, with emphasis on the latter. Rational bubbles, defined as the excess of security or portfolio prices over present values, can occur under conditions that are well understood. One argument relies on the assumed Pareto-optimality of equilibrium that rules out rational bubbles, but it is suggested that this argument is implausible.
Journal Article
Efficient Capital Markets and Martingales
A survey of the history of capital market efficiency shows that empirical tests of that efficiency are in practice usually tests of the martingale model. The survey also shows that the transition from the intuitive idea of market efficiency to the martingale model is not direct. Few financial economists have criticized the common practice of identifying market efficiency with a particular specialized model of financial market equilibrium. Failure to appreciate the difference between the interpretation of market efficiency as economic equilibrium and its interpretation as the martingale model means that financial economists have wavered in viewing market efficiency as part of their intellectual capital and unfalsifiable or as consisting of a specific class of falsifiable models of asset prices. Successful models of securities prices will need a broader analytical framework than they currently have, and the routine use of efficient-markets reasoning must be reassessed.
Journal Article
Examining the Sources of Excess Return Predictability: Stochastic Volatility or Market Inefficiency?
We use a consumption based asset pricing model to show that the predictability of excess returns on risky assets can arise from only two sources: (1) stochastic volatility of model variables, or (2) departures from rational expectations that give rise to predictable investor forecast errors and market inefficiency. From an empirical perspective, we investigate whether 1-month ahead excess returns on stocks can be predicted using measures of consumer sentiment and excess return momentum, while controlling directly and indirectly for the presence of stochastic volatility. A variable that interacts the 12-month sentiment change with recent return momentum is a robust predictor of excess stock returns both in-sample and out-of-sample. The predictive power of this variable derives mainly from periods when sentiment has been declining and return momentum is negative, forecasting a further decline in the excess stock return. We show that the sentiment-momentum variable is positively correlated with fluctuations in Google searches for the term “stock market,” suggesting that the sentiment-momentum variable helps to predict excess returns because it captures shifts in investor attention, particularly during stock market declines.
Paper
Liquidity and liquidation
The manager of a firm that is selling an illiquid asset has discretion as to the sale price: if he chooses a high (low) selling price, early sale is unlikely (likely). If the manager has the option to default on the debt that is collateralized by the illiquid asset, the optimal selling price depends on whether the manager acts in the interests of owners or creditors. We model the former case. In equilibrium the owner will always offer the illiquid asset for sale at a strictly higher price than he paid, and will default if he fails to sell. As a result, upon successful sales the illiquid asset changes hands at successively higher prices. We also consider a generalization of the model which permits sellers to finance sales using either debt or preferred stock, or both. This allows derivation of an optimal capital structure.
Journal Article