Forecasting risk, informed speculation, and financial innovation

How can an exchange maximise profits when informed speculators may drive hedgers out of the market? How do we avoid market failure in these cases? Here two types of market are created - small, stable markets for hedgers and a second larger, volatile market with greater volume that is attractive to speculative trading.

Forecasting risk, informed speculation, and financial innovation: "Speculators who prey on hedgers can stifle financial innovation in the sense that new markets can fail. In this paper I analyze whether a profit maximizing exchange nonetheless chooses to open markets for speculative securities and if so, how to circumvent the problem of market failure. I find that the optimal financial innovation takes two forms. The first is a market structure consisting of hedge instruments, traded in low volume at stable asset prices. The second is a market structure consisting of speculative instruments, traded in greater volume at volatile asset prices. These strategies are derived within the same framework where the cost and the quality of the speculators' information set and the hedgers risk aversion ultimately determine which is the optimal one"

US auto industry

Brad DeLong highlights the WSJ article about restructuring at Fords

Covering the Economy: Employment and Layoffs: Ford: " Ford plans for the future: WSJ.com - Ford Will Shed 28% of Workers In North America : By JEFFREY MCCRACKEN and JOSEPH B. WHITE Staff Reporters of THE WALL STREET JOURNAL January 24, 2006; Page A1: DETROIT -- Ford Motor Co. has made it official: Detroit is ditching its business model of the 1990s, and the cost now totals more than 60,000 jobs at Ford and rival General Motors Corp. Ford yesterday announced plans to close 14 North American factories, including seven assembly plants, and slash up to 34,000 North American jobs over the next six years. About a month ago, GM rolled out plans to cut almost as many jobs by 2010. Both companies will emerge from these retrenchments smaller, slugging it out in a crowded U.S. auto market.

However, the report also indicates that there are as many US auto jobs as there were in 1990. It is just that they are now jobs at foreign car plants.

Businessweek reports on the booming auto industry in AlabamaThe Alabama Surprise

This highlights the way that poor decisions and the burden of pension and healthcare costs are dragging the traditional US industry down. Does it matter?

Placebo effects

I think that there is further to go with this. Some institutions do have influence beyond their actual worth. A legal system provides confidence in property rights, the central bank can make sure that the financial system runs smoothly. We believe, so it is. It is even more important for society. Think inflation expectations.


Placebo effects: " In last night's Alternative Medicine on BBC2, the Perfect One talked about the power of placebo effects. Some apparently nonsensical treatments work, she said, if we expect them to. She says: NHS doctors are not taught the positive power of placebo. They’re told to reduce its effect for scientific research. This raises a question. If placebo effects are powerful in medicine, aren't they also likely to be powerful in the social sciences? Could it be that the power of some institutions derives not from their genuine mechanical ability to control things, but merely from our belief that they have power? In other words, the notion that institutions have power is  a self-fulfilling illusion.Here are three areas  where I reckon power might be due partly to a placebo effect:1. The media. The editorial lines and news content of the dead trees is determined by the profit motive , not by intellectual considerations. Why, then, do we believe newspapers have power? Could it be that their influence exists largely because we merely think it does? 2. Company bosses. Sure, entrepreneurship matters. But most bosses of large firms aren't entrepreneurs - they're just bureaucrats. If I were to say that such bureaucrats don't, generally speaking, improve firm performance, what could you do - other than cite a handful of except"

Bias in the estimate of speed of real exchange rate adjustment

On the speed of adjustment in ESTAR models when allowance is made for bias in estimation: "The purpose of this letter is to show, via simulation and bootstrap methods, that the estimates of the speed of adjustment parameter obtained in ESTAR models of the real exchange rate are upward biased in sample sizes typically employed in empirical work."

Aggregation of Euro area data

A look at different methods of aggregating euro area data.

On the aggregation of eurozone data: "Constructing eurozone aggregates is common practice in empirical studies. This study shows that the choice of aggregation method does not only matter on a theoretical basis. A brief study on eurozone money demand indicates the empirical importance of choosing the correct aggregation method as different aggregates give substantially different outcomes. "

Size matters for liquidity: Evidence from EMU sovereign yield spreads

Look at liquidity and the effect of EMU on sovereign yield spreads.

Size matters for liquidity: "The objective is to study the relative importance of domestic components of EMU sovereign yield spreads since the start of Monetary Integration. The results indicate a change in the market value of liquidity, as measured by market size, after EMU"

Has Financial Development Made the World Riskier?

Has risk increased with financial development.

SSRN-Has Financial Development Made the World Riskier? by Raghuram Rajan: "Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behavior makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk. "

Institutional Investors and Stock Market Volatility by Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou, H. Stanley

Large trades in an illiquid market.

SSRN-Institutional Investors and Stock Market Volatility by Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou, H. Stanley: "We present a theory of excess stock market volatility, in which market movements are due to trades by very large institutional investors in relatively illiquid markets. Such trades generate significant spikes in returns and volume, even in the absence of important news about fundamentals. We derive the optimal trading behavior of these investors, which allows us to provide a unified explanation for apparently disconnected empirical regularities in returns, trading volume and investor size. "

Foreign Direct Investment and Domestic Economic Activity by Mihir Desai, C. Foley, James Hines

Looking at the relationship between FDI and domestic investment.

SSRN-Foreign Direct Investment and Domestic Economic Activity by Mihir Desai, C. Foley, James Hines: "The data do not support the popular notion that greater foreign activity crowds out domestic activity by the same firms, instead suggesting the reverse. "

Japan and the World Economy : Current account: mean-reverting or random walk behavior?

ScienceDirect - Japan and the World Economy : Current account: mean-reverting or random walk behavior?: "This paper sets out to investigate the statistical properties of current account in the crisis-affected countries of East Asian (Asian-5: Indonesia, Korea, Malaysia, the Philippines and Thailand) utilizing data from 1976Q1 to 2001Q4. We split the full sample period into two sub-periods of the pre-crisis (1976Q1�1996Q4) and post-crisis (1997Q1�2001Q4) eras. Univariate unit root tests indicate that current account follows a non-stationary process under both eras. However, using more sophisticated panel techniques revealed that the current account displays mean-reverting property in all three sampling periods. Meanwhile, deviations of half-life estimates in the full sample period (post-crisis) were found to be much more rapid compared to the pre-crisis period. Our major conclusions are first, the empirical evidence supports the modern intertemporal approach to current account. Second, the results reveal that the Asian-5 current accounts were on a sustainable path, even during the pre-crisis period, hence, questioning the notion that the East Asian financial crisis was due to the mismanagement of external imbalances. "