Research articles for the 2019-07-28

Anatomy of Sudden Yen Appreciations
Han, Fei,Westelius, Niklas
The yen is an important barometer for the Japanese economy. Depreciations are typically associated with favorable economic developments such as increased corporate profits, rising equity prices, and upward pressure on domestic consumer prices. On the other hand, large and sharp appreciations run the risk of lowering actual and expected inflation, squeezing corporate profits, generating a negative wealth effect through depressed equity prices, and reducing confidence in the Bank of Japan's efforts to reflate the domestic economy and achieve the inflation target. This paper takes a closer look at underlying drivers of rapid yen appreciations, highlighting the key role of carry-trade and the zero lower bound as important amplifiers.

Conditional inference on the asset with maximum Sharpe ratio
Steven E. Pav

We apply the procedure of Lee et al. to the problem of performing inference on the signal noise ratio of the asset which displays maximum sample Sharpe ratio over a set of possibly correlated assets. We find a multivariate analogue of the commonly used approximate standard error of the Sharpe ratio to use in this conditional estimation procedure. We also consider the simple Bonferroni correction for multiple hypothesis testing, fixing it for the case of positive common correlation among assets.

Testing indicates the conditional inference procedure achieves nominal type I rate, and does not appear to suffer from non-normality of returns. The conditional estimation test has low power under the alternative where there is little spread in the signal noise ratios of the assets, and high power under the alternative where a single asset has high signal noise ratio.

Convergence of Optimal Expected Utility for a Sequence of Discrete-Time Markets
David M. Kreps,Walter Schachermayer

We examine Kreps' (2019) conjecture that optimal expected utility in the classic Black--Scholes--Merton (BSM) economy is the limit of optimal expected utility for a sequence of discrete-time economies that "approach" the BSM economy in a natural sense: The $n$th discrete-time economy is generated by a scaled $n$-step random walk, based on an unscaled random variable $\zeta$ with mean zero, variance one, and bounded support. We confirm Kreps' conjecture if the consumer's utility function $U$ has asymptotic elasticity strictly less than one, and we provide a counterexample to the conjecture for a utility function $U$ with asymptotic elasticity equal to 1, for $\zeta$ such that $E[\zeta^3] > 0.$

Informality and the Challenge of Pension Adequacy: Outlook and Reform Options for Peru
Freudenberg, Christoph,Toscani, Frederik
Past reforms have put the Peruvian pension system on a largely fiscally sustainable path, but the system faces important challenges in providing adequate pension levels for a large share of the population. Using administrative microdata at the affiliate level, we project replacement rates in the defined benefit (DB) and defined contribution (DC) pillars over the next 30 years and simulate the impact of various reform scenarios on the average level and distribution of pensions. In the DB pillar, the regressive minimum contribution period should be re-thought, while in the DC pillar a broadening of the contribution base and/or an increase in contribution rates would help increase replacement rates relative to the baseline forecast of 25-33 percent. A higher net real rate of return than assumed in the baseline would also have a significant positive impact. In the medium-term, labor market reform to tackle informality, and a broad pension reform to restructure the system and avoid competition between the DB and DC pillars should be a priority. Given low pension coverage, having a strong non-contributory pillar will remain important for the foreseeable future.

Long-Term Returns in Distressed Sovereign Bond Markets: How Did Investors Fare?
Andritzky, Jochen R.,Schumacher, Julian
Sovereign debt restructurings are perceived as inflicting large losses to bondholders.However, many bonds feature high coupons and often exhibit strong post-crisisrecoveries. To account for these aspects, we analyze the long-term returns of sovereignbonds during 32 crises since 1998, taking into account losses from bond exchanges as wellas profits before and after such events. We show that the average excess return over risk-freerates in crises with debt restructuring is not significantly lower than the return onbonds in crises without restructuring. Returns differ considerably depending on theinvestment strategy: Investors who sell during crises fare much worse than buy-and-holdinvestors or investors entering the market upon signs of distress

Network Structure and Naive Sequential Learning
Krishna Dasaratha,Kevin He

We study a sequential learning model featuring a network of naive agents with Gaussian information structures. Agents wrongly believe their predecessors act solely on private information, so they neglect redundancies among observed actions. We provide a simple linear formula expressing agents' actions in terms of network paths and use this formula to characterize the set of networks where naive agents eventually learn correctly. This characterization shows that, on all networks where later agents observe more than one neighbor, there exist disproportionately influential early agents who can cause herding on incorrect actions. Going beyond existing social-learning results, we compute the probability of such mislearning exactly. This allows us to compare likelihoods of incorrect herding, and hence expected welfare losses, across network structures. The probability of mislearning increases when link densities are higher and when networks are more integrated. In partially segregated networks, divergent early signals can lead to persistent disagreement between groups.

Network and Agent Dynamics with Evolving Protection against Systemic Risk
Chulwook Park

The dynamics of protection processes has been a fundamental challenge in systemic risk analysis. The conceptual principle and methodological techniques behind the mechanisms involved [in such dynamics] have been harder to grasp than researchers understood them to be. In this paper, we show how to construct a large variety of behaviors by applying a simple algorithm to networked agents, which could, conceivably, offer a straightforward way out of the complexity. The model starts with the probability that systemic risk spreads. Even in a very random social structure, the propagation of risk is guaranteed by an arbitrary network property of a set of elements. Despite intensive systemic risk, the potential of the absence of failure could also be driven when there has been a strong investment in protection through a heuristically evolved protection level. It is very interesting to discover that many applications are still seeking the mechanisms through which networked individuals build many of these protection process or mechanisms based on fitness due to evolutionary drift. Our implementation still needs to be polished against what happens in the real world, but in general, the approach could be useful for researchers and those who need to use protection dynamics to guard against systemic risk under intrinsic randomness in artificial circumstances.

Public Wealth in the United States
Gonguet, Fabien,Hellwig, Klaus-Peter
We analyze the US public sector balance sheet and project it forward under the assumption that current policies remain in place. We first document the history of the balance sheet and its components since World War II, with a detailed account of its evolution during and after the global financial crisis. While, based on assets and liabilities alone, public sector net worth is negative, additional challenges arise from commitments to future spending implied by current legislation and demographic trends. To quantify the risks to the balance sheet,we then apply the macroeconomic scenarios from the Federal Reserve's bank stress test to the public sector balance sheet.

Recommendation Engine for Lower Interest Borrowing on Peer to Peer Lending (P2PL) Platform
Ke Ren,Avinash Malik

Online Peer to Peer Lending (P2PL) systems connect lenders and borrowers directly, thereby making it convenient to borrow and lend money without intermediaries such as banks. Many recommendation systems have been developed for lenders to achieve higher interest rates and avoid defaulting loans. However, there has not been much research in developing recommendation systems to help borrowers make wise decisions. On P2PL platforms, borrowers can either apply for bidding loans, where the interest rate is determined by lenders bidding on a loan or traditional loans where the P2PL platform determines the interest rate. Different borrower grades -- determining the credit worthiness of borrowers get different interest rates via these two mechanisms. Hence, it is essential to determine which type of loans borrowers should apply for. In this paper, we build a recommendation system that recommends to any new borrower the type of loan they should apply for. Using our recommendation system, any borrower can achieve lowered interest rates with a higher likelihood of getting funded.

The Rewards of Fiscal Consolidation: Sovereign Spreads and Confidence Effects
David, Antonio C.,Guajardo, Jaime,Yépez, Juan F.
This paper investigates the effects of fiscal consolidation announcements on sovereign spreads in a panel of 21 emerging market economies during 2000-18. We construct a novel dataset using a global news database to identify the precise announcement date of fiscal consolidation actions. Our results show that sovereign spreads decline significantly following news that austerity measures have been approved by the legislature (congress or parliament), in periods of high sovereign spreads or in countries under an IMF program. In addition, consolidation announcements are less contractionary when sovereign spreads decline, with the reduction in output being half of the counterfactual case in which spreads do not respond to announcements. These results constitute direct evidence that confidence effects, in the form of lower sovereign spreads, are an important transmission channel of fiscal shocks. We also find that the role of confidence effects increases with the level of spreads such that countries with high spread levels stand to benefit the most from putting in place credible austerity packages.

Time-consistent feedback strategies with Volterra processes
Bingyan Han,Hoi Ying Wong

This paper investigates an equilibrium feedback control for time-inconsistent reward functionals when the state variable follows a Volterra process. As Volterra processes are non-Markovian and non-semimartingale in general, we develop an extended path-dependent Hamilton-Jacobi-Bellman (PHJB) equation system and offer a verification theorem to the solution of the PHJB equation. We apply the theory to three time-inconsistent problems when the risky asset price follows the Volterra Heston model, a typical rough volatility model. Analytical solutions are derived for the three problems: mean-variance portfolio problem (MVP) with constant risk aversion, MVP with a state-dependent risk aversion, and an investment/consumption problem with non-exponential discounting. Through these examples, we address the effects of roughness on equilibrium strategies.