DOCSLIB.ORG

Essays on Information in Options Markets A

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Essays on Information in Options Markets A ESSAYS ON INFORMATION IN OPTIONS MARKETS A DISSERTATION SUBMITTED TO THE GRADUATE SCHOOL OF BUSINESS AND THE COMMITTEE ON GRADUATE STUDIES OF STANFORD UNIVERSITY IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY Travis L. Johnson May 2012 © 2012 by Travis Lake Johnson. All Rights Reserved. Re-distributed by Stanford University under license with the author. This work is licensed under a Creative Commons Attribution- Noncommercial 3.0 United States License. http://creativecommons.org/licenses/by-nc/3.0/us/ This dissertation is online at: http://purl.stanford.edu/hf166pb0337 ii I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Anat Admati, Primary Adviser I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Ian Martin I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Stefan Nagel I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Paul Pfleiderer Approved for the Stanford University Committee on Graduate Studies. Patricia J. Gumport, Vice Provost Graduate Education This signature page was generated electronically upon submission of this dissertation in electronic format. An original signed hard copy of the signature page is on file in University Archives. iii Abstract In the first chapter, my coauthor and I examine the information content of option and equity volumes when trade direction is unobserved. In a multimarket asymmet- ric information model, equity short-sale costs result in a negative relation between relative option volume and future firm value. In our empirical tests, firms in the lowest decile of the option to stock volume ratio (O/S) outperform the highest decile by 0.34% per week (19.3% annualized). Our model and empirics both indicate that O/S is a stronger signal when short-sale costs are high or option leverage is low. O/S also predicts future firm-specific earnings news, consistent with O/S reflecting private information. In the second chapter, I show that in many asset pricing models, the equity mar- ket's expected return is a time-invariant linear function of its conditional variance, which can be estimated from options markets. However, I show that when the relation between conditional means and variances is state-dependent, an observer requires the combined information in multiple variance horizons to distinguish among the states and thereby reveal the equity risk premium. Empirically, I show that while the VIX by itself has little predictive power for future S&P 500 returns, the VIX term structure predicts next-quarter S&P 500 returns with a 5.2% adjusted R2. iv Acknowledgements The first chapter of this dissertation is co-authored with Eric C. So. Thanks to my advisor Anat Admati, and my reading committee Ian Martin, Stefan Nagel, and Paul Pfleiderer, for their comments and guidance. Thanks to an anonymous referee, Mary Barth, Darrell Duffie, Jeff Harris, Sebas- tian Infante, Charles Lee, Arthur Korteweg, Kristoffer Laursen, Ian Martin, Stefan Nagel, Paul Pfleiderer, Monika Piazzesi, Ken Singleton, and seminar participants at Boston College, Dartmouth College, Rice University, SAC Capital Advisors, Stan- ford University, University of California-Berkeley, University of Houston, University of Maryland, University of Notre Dame, University of Pennsylvania, University of Rochester, University of Texas-Austin, University of Wisconsin-Madison, and the Western Finance Association meetings, for their helpful comments and suggestions. Thanks to Data Explorers for graciously providing us institutional lending data. v Contents Abstract iv Acknowledgements v 1 Introduction 1 2 The Option to Stock Volume Ratio and Future Returns 3 2.1 Introduction . 3 2.2 Relation to prior research . 6 2.3 The model . 10 A Equilibrium . 12 B Results and empirical predictions . 14 2.4 Empirical tests . 17 2.5 Additional analyses . 34 2.6 Conclusion . 37 2.7 Tables and Figures . 40 3 Equity Risk Premia and the VIX Term Structure 54 3.1 Introduction . 54 3.2 Relation to prior research . 56 3.3 Model . 61 A A three-factor model of variance and risk premia . 65 3.4 Empirical results . 71 3.5 Conclusion . 77 3.6 Figures and Tables . 78 vi A Appendices for Chapter 2 91 A.1 Simultaneous equations . 91 A.2 Measure of leverage . 93 A.3 Proofs . 93 B Appendices for Chapter 3 102 B.1 Conditional means and variances in prior models . 102 A Bansal and Yaron (2004) . 102 B Campbell and Cochrane (1999) . 103 B.2 Details of Proofs . 103 B.3 Continuous version of the model . 106 A Risk and Return in the Model . 108 B Matching Moments . 110 Bibliography 113 vii List of Tables 2.1 Descriptive statistics by year. 42 2.2 Factor regression results by deciles of O/S, ∆O/S, and ΩO/S. 43 2.3 Fama-MacBeth multivariate regressions. 47 2.4 Strategy alphas sorted by short-sale costs. 49 2.5 Option volume alphas sorted by leverage. 51 2.6 Future return skewness by deciles of call-put volume ratio. 52 2.7 Earnings surprises and earnings announcement returns. 53 3.1 Data and Calibrated Model Moments . 82 3.2 Descriptive Statistics of Term Structure . 83 3.3 Return Prediction Regressions . 84 3.4 Principal Components (Full Sample) . 87 3.5 Principal Components (No 2008-2009 Financial Crisis) . 89 B.1 Summary of Model Notation . 108 B.2 Data and Calibrated Model Moments . 111 viii List of Figures 2.1 Persistence of O/S-return relation. 40 2.2 Cumulative hedge returns by year. 41 3.1 Model Equity Risk Premia and the VIX Term Structure . 78 2 3.2 Functions integrated to compute VIX12 on January 2nd, 1996. 79 3.3 Time Series of the Term Structure . 80 3.4 Return predictability factors in the VIX term structure . 81 B.1 Risk premia and variances in Campbell and Cochrane (1999). 104 ix Chapter 1 Introduction Classical finance theory assumes derivatives like options are redundant securities that can be perfectly replicated using the underlying asset. Transaction costs, incomplete markets, and asymmetric information are all examples of market imperfections that make accurate replication impossible, implying derivative markets are not redun- dant and may provide an alternative channel for fundamental information to reach investors. My dissertation research explores the non-redundant information about underly- ing assets provided by option markets. Pursuant to this agenda, I have two distinct chapters, each relying on option market data as a source of information about the economics of financial markets. The first chapter, \The Option to Stock Volume Ratio and Future Returns," is co-authored with Eric So, an accounting student here Stanford. Eric and I shared responsibility for all parts of the paper: the theory, the empirics, the writing, and the editing. The paper has been accepted at the Journal of Financial Economics but hasn't yet been published. In the paper, we examine the information content of option and equity volumes when trade direction is unobserved. In a multimarket asymmetric information model, equity short-sale costs result in a negative relation between relative option volume and future firm value. In our empirical tests, firms in the lowest decile of the option to stock volume ratio (O/S) outperform the highest decile by 0.34% per week (19.3% annualized). Our model and empirics both indicate that O/S is a stronger signal when short-sale costs are high or option leverage is low. 1 CHAPTER 1. INTRODUCTION 2 O/S also predicts future firm-specific earnings news, consistent with O/S reflecting private information. The second chapter, \Equity Risk Premia and the VIX Term Structure" is my job market paper. In it, I show that in many asset pricing models, the equity market's expected return is a time-invariant linear function of its conditional variance, which can be estimated from options markets. However, I show that when the relation between conditional means and variances is state-dependent, an observer requires the combined information in multiple variance horizons to distinguish among the states and thereby reveal the equity risk premium. Empirically, I show that while the VIX by itself has little predictive power for future S&P 500 returns, the VIX term structure predicts next-quarter S&P 500 returns with a 5.2% adjusted R2. Chapter 2 The Option to Stock Volume Ratio and Future Returns 2.1 Introduction In recent decades, the availability of derivative securities has rapidly expanded. This expansion is not limited to equity options and now includes a vast array of securities ranging from currency options to credit default swaps. Derivatives contribute to price discovery because they allow traders to better align their strategies with the sign and magnitude of their information. The leverage in derivative securities, combined with this alignment, creates additional incentives to generate private information. In this way, trades in derivative markets may provide more refined and precise signals of the underlying asset's value than trades of the asset itself. Understanding how and why derivatives affect price discovery is therefore vital to understanding how information comes to be in asset prices. This study focuses on the information content of trading volumes. Observed transactions play an important role in price discovery because order flow imbalances can reflect the sign and magnitude of private information.
Load more

Recommended publications
  • Comment for the Treasury Select Committee Capital Inquiry
    Comment for the Treasury Select Committee Capital Inquiry Recovery and Resolution Anat R. Admati George G.C. Parker Professor of Finance and Economics Graduate School of Business, Stanford University March 5, 2017 1. Introduction I commend the Treasury Committee for undertaking this extremely important inquiry. Since the financial sector is such a large part of the UK economy, these issues are critical. A large, fragile and reckless system has the potential to cause enormous harm to UK citizens and beyond. My short answer to the main question of whether current regulations, including resolution plans, have “ended too big to fail” is No. This opinion is hardly controversial. Many share it, including former governor of the Bank of England Sir Mervyn King who called for radical reforms in his 2016 book, asserting that without reform, another financial crisis is certain. The banking system, and particularly the largest UK financial institutions, remains much too fragile and inefficient, and it continues to endanger UK citizens unnecessarily. Too big to fail institutions distort competition, misallocate resources and harm both by borrowing too much and taking excessive risk and by misconduct. The Bank of England has not done all it can to address the too-big-to-fail problem and protect the public. Individuals representing the Bank of England have made misleading statements in this regard. I will try to clarify the issues and explain these statements briefly. I, and others, have written extensively since 2010 exposing the persistent flaws in the regulations. UK citizens ultimately bear the consequences of this policy failure, and they are significant and unnecessary.
    [Show full text]
  • John H. Cochrane February 2021 Contact: Hoover Institution, Stanford
    John H. Cochrane February 2021 Contact: Hoover Institution, Stanford University 434 Galvez Mall Stanford, CA 94305-6010 Tel 650 723 6708 Email: [email protected] Website: https://www.johnhcochrane.com Education: 1979-1985: University of California, Berkeley. Ph.D. in Economics, awarded June 1986 1975-1979: MIT. S.B. in Physics awarded June 1979 Employment: 2015 – now: Rose-Marie and Jack Anderson Senior Fellow, Hoover Institution, Stanford University. 1994 – 2015: University of Chicago Booth School of Business. AQR Capital Management Distinguished Service Professor of Finance. 2000 - 2001: UCLA, Anderson Graduate School of Management. Visiting Professor of Finance. 1985 – 1994: University of Chicago Department of Economics. Assistant and Associate Professor. 1991 – 1992: University of Chicago, Graduate School of Business. Visiting Associate Professor. 1982 – 1983: Council of Economic Advisers. Junior Staff Economist for Macroeconomics. Current Affiliations and Professional Activities: 2016-: Professor of Finance and Economics (by Courtesy), Stanford GSB 2015-: Distinguished Research Fellow, Becker-Friedman Institute, University of Chicago 2015-: Senior Fellow, SIEPR, Stanford University 2015-2020: Distinguished Senior Fellow, Booth School of Business, University of Chicago 2009-: Adjunct Scholar, CATO institute 2007-: Editorial Board, American Economic Journal: Macroeconomics 1998-: NBER Research Associate Past Affiliations and Professional Activities 2012 - 2015: Senior Fellow, (nonresident) Hoover Institution, Stanford University
    [Show full text]
  • Myths About the Stability and Efficiency of Global Finance
    Myths about the Stability and Efficiency of Global Finance Anat Admati Graduate School of Business Stanford University Fields / OECD-NAEC / Rebuilding Macroeconomics Symposium on Systemic Recovery, April 27, 2021 1 Is the financial system “sufficiently” resilient? NO, it is too fragile every day!! Is the system efficient? NO, it is bloated and distorted every day!! Is there a tradeoff between resiliency and efficiency in finance? NO, finance can be improved at no social cost!! Power in Finance: People, Institutions, and Markets Financial Institutions and Markets Central Banks Individuals Non-Financial Institutions and Markets Governments and (“Real Economy”) their Institutions Including media The Economy is a Web of Legal Promises (IOUs), People and Entities What happens if a “shock” disrupts someone’s ability to fulfill promise? ● Household debt ● Small and medium size enterprise debt ● Corporate debt ● Contingent liabilities (derivatives, insurance) ● Other contracts How Finance Can Benefit Society Payment Money Risk Guiding System Across Time Sharing Investments Cash or private beneficial exchange Insurance and Scrutiny, pricing, debt claims diversification monitoring Should be trustworthy and efficient. Making Finance Work Too Little… Too Much… ● “Unbanked” ● Huge, complex, and opaque system. ● Cumbersome payments and trade ● Highly interconnected ● Difficult to save and fund investments ● Enormous “systemic” institutions ● Exposure to downside risks ● Appears inefficient and reckless How to enable “enough” finance but avoid “too much?” Key for “Proper” Financial Development Education Effective laws, Technology (financial literacy) regulations, and (mostly for enforcement payment system) Literacy and effective rules and enforcement are key Myths about Global Finance: All are False! The financial system Reformed regulations Global financial is much safer than it are “science-based” markets allocate was before 2007 and address “TBTF” resources efficiently [These events] present a challenge to standard economic theory….
    [Show full text]
  • Ten Years After the Crisis: Looking Back, Looking Forward
    TEN YEARS AFTER THE CRISIS: LOOKING BACK, LOOKING FORWARD 22 September 2017 A CEPR conference Sponsored by the Brevan Howard Centre for Financial Analysis, Imperial College Business School Hosted by EY, 25 Churchill Place, London E14 5RB PROGRAMME 08:30 - 09:00 Coffee and registration 09:00 - 09:45 Opening address by Mario Monti (Università Bocconi) FINANCIAL STABILITY: HAS REGULATORY REFORM GONE FAR ENOUGH? Moderator: Martin Sandbu (Financial Times) 09:45 - 09:50 Introduction 09:50 - 11:15 Vittorio Grilli (JP Morgan and CEPR) Catherine L. Mann (OECD) John Vickers (University of Oxford) 11:15 - 11:45 Coffee Break KEY ISSUES: TOO BIG TO FAIL, DERIVATIVE MARKETS, SHADOW BANKING Moderator: Martin Sandbu (Financial Times) 11:45 - 11:50 Introduction 11:50 - 13:15 Tamim Bayoumi (IMF) Charles Goodhart (London School of Economics and CEPR) Tom Huertas (EY) 13:15 - 13:45 Lunch 13:45 - 14:15 Keynote Speech: “The Great Recession as Great Refutation” Paul Krugman (Princeton University and CEPR) 1 WHERE COULD THE NEXT CRISIS COME FROM? ADVANCED & EMERGING ECONOMIES Moderator: Stephanie Flanders 14:15 - 14:20 Introduction 14:20 - 15:45 Christian Thimann (AXA) Paul Tucker (Harvard University and Chair, Systemic Risk Council) Shang-Jin Wei (Columbia Business School and CEPR) 15:45 - 16:15 Coffee Break CONCLUSIONS: PERSPECTIVES NOW AND IN 2007 Moderator: Stephanie Flanders 16:15 - 16:20 Introduction 16:20 - 17:45 Anat Admati (Stanford University) Randy Kroszner (University of Chicago, Booth School of Business) Klaus Regling (European Stability Mechanism) 17:45 Drinks Reception 2 TEN YEARS AFTER THE CRISIS: LOOKING BACK, LOOKING FORWARD 22 September 2017 A CEPR conference Sponsored by the Brevan Howard Centre for Financial Analysis, Imperial College Business School Hosted by EY, 25 Churchill Place, London E14 5RB BIOGRAPHIES Anat Admati is the George G.C.
    [Show full text]
  • Coining It in How Companies Are Hoping That It’S Business As Usual
    COINING IT IN HOW COMPANIES ARE HOPING THAT IT’S BUSINESS AS USUAL Coining it in How companies are hoping that it’s business as usual 1 Introduction Despite the global financial crisis, despite phenomenal quantities of public money being needed to keep the financial system afloat, despite many of the world’s economies being plunged into recession as a consequence, the men in charge of the world’s major companies (they are, almost without exception, men) are continuing to enjoy their pay and rewards. Executive pay is rocketing. How is it possible? It is possible because executive pay and bonuses are linked with company performance or, in other words, with how much profit gets made. And the real scandal – a bigger scandal even than the bloated size of executives’ pay – is that these profits are continuing to be turned in at grossly excessive levels. Ordinary people are paying the costs of the crisis. Companies, and their investors, are still enjoying good times. This report looks beyond the bonus into how business is setting unrealistic targets for corporate returns, the pursuit of which triggers false expectations, erroneous behaviour, threats to investment and ‘forced’ pressure to reduce labour costs. The policy of setting unrealistic rates of return on equity spilled over into the rest of the economy from the finance sector. This policy is unsustainable. Coining it in: How companies are hoping that it’s business as usual 1/32 2 Taking a lead from the banks We’ll begin by considering the banks. It was the banks which drove the world headlong into the financial crisis of 2007-8.
    [Show full text]
  • Anat Admati (Stanford University)
    International Banking and macroprudential spillovers Comments for Policy Panel Anat Admati Stanford University IMF‐IBRN Conference, Washington DC, April 19, 2017 The Bad News • Regulatory reform is an unfocused, complex mess. • The financial system is reckless and distorted every day. “Without reform... another crisis is certain.” Mervyn King, End of Alchemy, March 2016 1 2 “Macroprudential” • Fuzzy concept, multiple goals; e.g., – Protect the financial system from macroeconomic shocks – Monitor “systemic risk” arising from the financial sector that can harm the broader economy – Prevent “asset price bubbles” and excessive credit • Macroprudential vs microprudential is false dichotomy. – Well‐designed microprudential regulations can achieve many macroprudential policy goals. – Effective microprudential tools are “regulatory bargains.” Heavy Indebtedness Causes Great Inefficiencies and Collateral Harm • True for households, hence LTV, DTI regulations can be useful. • Subsidizing mortgage debt and corporate debt relative to equity is bad, distortive policy that should change. – Tax and other debt subsidies for housing and for corporations are distortive and inefficient, particularly perverse for banks. • Heavily indebted corporations, including banks, make inefficient investment and funding decisions. – Excessive risk taking and use of debt (“addiction”). – Underinvestment in worthy projects and leverage reduction. 3 THE LEVERAGE RATCHET EFFECT (Forthcoming Journal of Finance) Anat Admati Martin Hellwig Stanford Max Planck Peter DeMarzo
    [Show full text]
  • Annual Hyman P. Minsky Conference on the State of the US and World Economies Program
    Conference Proceedings Levy Economics Institute of Bard College rd annual hyman p. minsky conference on the state of the us and 23world economies Stabilizing Financial Systems for Growth and Full Employment April 9–10, 2014 The National Press Club, Washington, D.C. A conference organized by the Levy Economics Institute with support from the Ford Foundation Contents FOREWORD 1 PROGRAM 2 WELCOME AND INTRODUCTION Dimitri B. Papadimitriou 5 SPEAKERS Carolyn B. Maloney 8 Sherrod Brown 13 Charles L. Evans 19 Daniel K. Tarullo 29 Peter Praet 39 Jason Furman 50 Vítor Constâncio 70 SESSIONS 1. Financial Reregulation to Support Growth and Employment 82 2. Financial Regulation and Economic Stability: Was Dodd-Frank Enough, or Too Much? 87 3. The Global Growth and Employment Outlook: Cloudy with a Risk of . ? 91 4. The Euro and European Growth and Employment Prospects 96 5. What Are the Monetary Constraints to Sustainable Recovery of Employment? 101 PARTICIPANTS 106 These proceedings consist of edited transcripts of the speakers’ remarks and summaries of session participants’ presentations. Foreword I am delighted to welcome you to the 23rd Annual Hyman P. Minsky Conference, “Stabilizing Financial Systems for Growth and Full Employment,” organized by the Levy Economics Institute with support from the Ford Foundation. As part of its monetary policy research, the Institute is partnering with the Ford Foundation to examine financial instability and the reregulation of financial institutions and markets within the context of Minsky’s path-breaking work on financial crises. Despite the appearance of greater stability in the US financial system since the 2008–09 global recession, the economic recovery remains fragile and uneven, and social conditions are expected to improve even more slowly.
    [Show full text]
  • The Twelve Federal Reserve Banks: Governance And
    Working Paper #10 March 2, 2015 THE TWELVE FEDERAL RESERVE BANKS: GOVERNANCE AND ACCOUNTABILITY IN THE 21ST CENTURY Peter Conti-Brown Academic Fellow Stanford Law School Rock Center for Corporate Governance SUMMARY Chronicling the politics that led to the creation of the twelve Reserve Banks and the pursuant legal and political consequences, this paper argues that the Federal Reserve’s quasi-private Reserve Banks are, at best, opaque and unaccountable, and, at worst, unconstitutional. Following the Panic of 1907, one of the most destructive in the nation’s history, Republicans and Democrats offered competing proposals to overhaul the nation’s monetary system. Republicans wanted a single central bank, whereas Democrats wanted multiple independent reserve banks across the country that could tailor policy to local conditions. In both plans, private bankers would determine central bank leadership. As a compromise, President Woodrow Wilson proposed the creation of 8 – 12 reserve banks run by appointees of private bankers, but supervised by a single central board of Presidential appointees. Wilson’s vision formed the basis of the Federal Reserve Act of 1913, the Fed’s founding statute. The Wilsonian structure resulted in turf battles between the private Reserve Banks and the public Board in Washington, which led to policy uncertainty that contributed to the Great Depression. In response to this uncertainty, Congress, at the insistence of President Roosevelt, revoked Wilson's vision and centralized authority in the Board of Governors in Washington. But while the Depression-era legislation removed the 12 quasi-private Reserve Banks' autonomy, it did not eliminate them. This structure, which persists today, presents problems for both constitutional law and public policy.
    [Show full text]
  • Economic Perspectives
    The Journal of The Journal of Economic Perspectives Economic Perspectives The Journal of Summer 2017, Volume 31, Number 3 Economic Perspectives Symposia The Global Monetary System Maurice Obstfeld and Alan M. Taylor, “International Monetary Relations: Taking Finance Seriously” Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas, “The Safe Assets Shortage Conundrum” Kenneth Rogoff, “Dealing with Monetary Paralysis at the Zero Bound” The Modern Corporation Kathleen M. Kahle and René M. Stulz, “Is the US Public Corporation in Trouble?” A journal of the Lucian A. Bebchuk, Alma Cohen, and Scott Hirst, “The Agency Problems American Economic Association of Institutional Investors” Luigi Zingales, “Towards a Political Theory of the Firm” Summer 2017 Volume 31, Number 3 Summer 2017 Volume Anat R. Admati, “A Skeptical View of Financialized Corporate Governance” Articles Diego Restuccia and Richard Rogerson, “The Causes and Costs of Misallocation” Douglas W. Elmendorf and Louise M. Sheiner, “Federal Budget Policy with an Aging Population and Persistently Low Interest Rates” Joel Waldfogel, “How Digitization Has Created a Golden Age of Music, Movies, Books, and Television” Features Samuel Bowles, Alan Kirman, and Rajiv Sethi, “Retrospectives: Friedrich Hayek and the Market Algorithm” Population Control Policies and Fertility Convergence Tiloka de Silva and Silvana Tenreyro Recommendations for Further Reading Summer 2017 The American Economic Association The Journal of Correspondence relating to advertising, busi- Founded in 1885 ness matters, permission to quote, or change Economic Perspectives of address should be sent to the AEA business EXECUTIVE COMMITTEE office: [email protected]. Street ad- Elected Officers and Members A journal of the American Economic Association dress: American Economic Association, 2014 Broadway, Suite 305, Nashville, TN 37203.
    [Show full text]
  • Working Paper (First Draft August 2010)
    The Compelling Case for Stronger and More Effective Leverage Regulation in Banking Anat R. Admati* Graduate School of Business, Stanford University October 14, 2013 This Version September 28, 2014 Forthcoming, Journal of Legal Studies *This paper was presented at the Conference on Benefit-Cost Analysis of Financial Regulation at the University of Chicago Law School, October 18, 2013. I am grateful to Yakov Amihud, Martin Hellwig, Paul Pfleiderer, Eric Posner and an anonymous referee for helpful comments. Contact information: [email protected] Abstract Excessive leverage (indebtedness) in banking endangers the public and distorts the economy. Yet current and proposed regulations only tweak previous regulations that failed to provide financial stability. This paper discusses the forces that have led to this situation, some of which appear to be misunderstood. The benefits to society of requiring that financial institutions use significantly more equity funding than the status quo are large, while any costs are entirely private and due to banks' ability to shift some of their costs to others when they use debt. Without quantitative analysis, I outline improved regulations and how they can be implemented. 1. Introduction Good decisions require balancing the benefits and costs of possible actions. A proper assessment of the impact of regulations must aggregate the various costs and benefits for society. Good regulations offset private costs to the regulated by significantly larger benefits to others. The financial crisis of 2007-2009 highlighted the fragility of the financial system and the great harm it can cause. This fragility is greatly exacerbated by the fact that banks use extremely little equity (money from their owners and shareholders) to fund their investment.
    [Show full text]
  • VOLCKER RULE Restrictions on Banking Activity and Their Consequences for Economic Growth and Stability by Derek Thieme
    No. 14 SUMMER 2013 MERCATUS GRADUATE POLICY ESSAY ECONOMIC EFFECTS OF THE VOLCKER RULE Restrictions on Banking Activity and Their Consequences for Economic Growth and Stability by Derek Thieme The opinions expressed in this Graduate Policy Essay are the author’s and do not represent official positions of the Mercatus Center or George Mason University. Abstract: The Volcker Rule—a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act—restricts commercial banks from trading securities for their own accounts and limits their ability to affiliate with hedge funds and private-equity firms. The rule is intended to limit risk in the financial system by restricting institutions that are supported by public institutions from taking on risk that may ultimately be borne by taxpayers. This essay uses economic theory to examine the justification for such a rule, whether the rule is likely to be effective, and the additional economic effects that may arise from having the rule in place. The research in this essay suggests that the rule is unlikely to limit risk in the way that its supporters hope, because it attempts to work around, rather than address, a fundamental source of risk in the financial system: the moral hazard that results from public institutions providing support to banks and their creditors, which creates incentives for banks to assume more risk than they would otherwise. Author Bio: Derek Thieme grew up in Fort Wayne, Indiana, and received his BA in economics from Carthage College in 2009. During college he enjoyed working with other students who were interested in economics, and he helped establish a chapter of Omicron Delta Epsilon, an international economics fraternity, at Carthage.
    [Show full text]
  • Economics.Pdf
    UNDERGRADUATE PROGRAMS ECONOMICS BACHELOR OF ARTS Emeriti: (Professors) Takeshi Amemiya, Masahiko Aoki, Kenneth J. The total number of units required for the major is 80. Students are Arrow, Paul A. David, Victor R. Fuchs, John G. Gurley, Peter J. encouraged to complete the core courses 1-6 below, as early as possible. Hammond, Donald Harris, Bert G. Hickman, Lawrence J. Lau, Ronald Ideally, students should complete the core during the sophomore year, I. McKinnon, Roger G. Noll, Nathan Rosenberg, Thomas Sargent, before taking upper division courses. Courses may not be taken before David A. Starrett, Joseph E. Stiglitz the prerequisites are completed. The required number of field courses is Honorary Emerita (Professor): Anne O. Krueger four. There is great flexibility in the choice of electives, including upper- Chair: Timothy F. Bresnahan division math and statistics. Professors: B. Douglas Bernheim, Michael J. Boskin, Timothy F. Of the 80 units required for the major, at least 55 must be taken at Stan- Bresnahan, Lawrence Goulder, Avner Greif, Robert E. Hall, Han Hong, ford in California. Students cannot declare Economics as their major or Caroline Hoxby, Matthew O. Jackson, Peter Klenow, Mordecai Kurz, minor until they have completed ECON 50 with a grade of ‘B’ or better. Thomas E. MaCurdy, Paul R. Milgrom, John H. Pencavel, Joseph Romano, Ilya Segal, John B. Shoven, Robert Staiger, John B. Taylor, REQUIREMENTS FOR THE ECONOMICS MAJOR Frank Wolak, Gavin Wright (80 UNITS) Associate Professors: Liran Einav, Jonathan Levin, Luigi Pistaferri 1. ECON 1A (5 units): micro and elementary economics. Assistant Professors: Ran Abramitzky, Manuel Amador, Nicholas A.
    [Show full text]