Alexander David

Fluctuating Confidence in Stock Markets: Implications for Returns and Volatility

The average relative profitability of different firms in the economy jumps erratically. Although investors are unable to observe these productivity switches, they continuously update their beliefs regarding high and low productivity firms by observing the total return on each firm, which consists of the average productivity plus noise. The portfolio choices, interest rate, and stock return processes are derived in a Cox-Ingersoll-Ross (1985a) style general equilibrium model. Three stylized facts of stock market returns are addressed: negative skewness, excess kurtosis, and predictive asymmetry (excess returns and future changes in volatility are negatively correlated). To measure the last stylized fact, an EGARCH model is fitted to sample paths simulated from the model. Parameter values that permit faster learning fit the three facts better.

What Ties Return Volatilities to Price Valuations and Fundamentals

Stock and Treasury bond comovement, volatilities, and their relations to their price valuations and fundamentals change stochastically over time, in both magnitude and direction. These stochastic changes are explained by a general equilibrium model in which agents learn about composite economic and inflation regimes. We estimate our model using both fundamentals and asset prices and find that inflation news signal either positive or negative future real economic growth depending on the times, thereby affecting the direction of stock-bond comovement. The learning dynamics generate strong nonlinearities between volatilities and price valuations. We find empirical support for numerous predictions of the model.

Pricing the strategic value of putable securities in liquidity crises

Putable security holders have a de facto first claim on the firms liquid assets and can threaten to force solvent issuers to bear financial distress costs. Their threatening power implies that the puts have a strategic value larger than their intrinsic value. Strategic value depends on the issuers size, potential distress costs, and the distribution of put ownership relative to the firms liquidity position. The analysis of Kmarts put-induced crisis in 1995, and a calibration to observed secondary market yield reductions on poison put bonds, shows that strategic value is an important determinant of payouts received by bondholders.

Exploration Activity, Long Run Decisions, and the Risk Premium in Energy Futures

We present evidence that the capital stock of firms in oil and gas exploration as well as oil inventories are each positively related to the slope of the futures curve, and negatively predict returns on holding crude oil futures contracts. We build an equilibrium model of resource extraction, exploration, and storage with these features. Capital lowers extraction costs as firms drill in increasingly expensive fields, while inventory helps smooth fluctuations in demand and extraction. The model sheds light on the role of declining well quality on the recent positive trend of real oil prices, and the peaking of consumption.

Imperfect Renegotiations in Interbank Financial Networks

Interbank financial networks enable banks to share the risks in their assets but potentially also increase systemic spillovers of insolvency from one bank to others in the network. We model a renegotiation game to explicitly examine the forgiveness of commitments of insolvent banks by solvent banks to limit the systemic transmission of financial distress. The assets of the insolvent bank can be appropriated by the forgiving bank in the two-bank network, but not the three-bank network, where they may be appropriated by the third bank, leading to a renegotiation breakdown. We also show how banks can ex ante optimally construct networks from interbank loans and derivatives to minimize the costs of such inefficient financial distress. This paper was accepted by Itay Goldstein, finance.

Pricing the Strategic Value of Poison Put Bonds

In times of low liquidity for a firm, poison put bondholders can threaten to either force the company into a reorganization or to raise its borrowing costs. A multilateral bargaining solution for the strategic value is formulated at the time of exercise. Even infinitesimal bondholders, putting non-cooperatively, are able to extract more than the intrinsic value whenever the amount of putable debt exceeds the firms effective liquidity. Prior to the crisis all financial assets are priced in a continuous-time framework when interest rates follow the Vasicek process and firms debtholders are subject to a sharp price decline due to an LBO. The model is calibrated to one such recent crisis --- that of Kmart Corp.