Alon Raviv

Inflating Away the Public Debt? An Empirical Assessment

We propose and implement a method that provides quantitative estimates of the extent to which higher-than-expected inflation can lower the real value of outstanding government debt. Looking forward, we derive a formula for the debt burden that relies on detailed information about debt maturity and claimholders, and that uses option prices to construct risk-adjusted probability distributions for inflation at different horizons. The estimates suggest that it is unlikely that inflation will lower the US fiscal burden significantly, and that the effect of higher inflation is modest for plausible counterfactuals. If instead inflation is combined with financial repression that ex post extends the maturity of the debt, then the reduction in value can be significant.

Executive Compensation, Risk Taking and the State of the Economy

In this paper we present a model of executive compensation to analyze the link between incentive compensation and risk taking. Our model takes into account the loss in the value of an executives expected wealth from employment if the firm becomes insolvent during a bad state of the economy. We illustrate that a given compensation package may lead to different levels of asset risk under different economic states. More specifically, we show that the positive relationship between equity-based compensation and risk taking may weaken and possibly disappear during systemic financial crises. An important policy implication from our analysis is that similar regulations may have different effects on risk taking depending on the state of the economy.

How Much Can Illiquidity Affect Corporate Debt Yield Spread

We present a structural method for measuring the upper bound for the illiquidity risk of liabilities issued by a levered firm. The method calculates the upper bound of illiquidity spread of a corporate bond given its duration and the issuing firm’s asset risk and leverage ratio. Consistent with the empirical literature the illiquidity spread is positively related to the issuing firm’s asset risk and leverage ratio and the illiquidity component increases with a bond’s credit quality. The term structure of illiquidity spread has a humped shape, where its maximum level depends on the firm’s leverage ratio. Finally, we demonstrate how the method’s implied restricted trading period can be used as a measure for illiquidity in the bonds’ market.

A Balance Sheet Approach for Sovereign Debt

A sovereign that is issuing debt denominated in foreign currency is exposed to a mismatch between the value of its assets that can be used to serve the debt, denominated in local currency, and the value of its liability. During economic crisis, when the probability of default by the sovereign increases, there is a tendency for the exchange rate to experience sudden shock. Such a relationship has been observed in most of the recent financial crises in emerging markets (for example, in the East Asian crisis of 1997 and the Russian debt crisis of 1998). In this paper we develop a structural model for pricing sovereign debt that is denominated in foreign currency where the effect of local economic crisis on the exchange rate is considered through a state-dependent jump intensity variable that is sensitive to the distance of default of the sovereign debt. The presented pricing model can produce a higher credit spread than the classical Merton-based approach (1974) for risky debt. The model can help traders, risk managers, accountants, and policymakers who are interested in more accurately evaluating the fair value of sovereign debt that is denominated in foreign currency.

Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions

We present an equilibrium model of financial institutions in which we examine the optimal regulation of risk taking. Choice of risk levels result from strategic interactions of regulators, shareholders, and management. Regulators use caps on asset risk and equity-based compensation to achieve the optimal level of risk; shareholders choose levels of managements stock ownership; and management chooses asset risk. We characterize the socially optimal level of risk. If there is perfect information and enforcement, using one policy tool is sufficient. If enforcement is limited or information is asymmetric, there can be gains to social welfare from employing both policy tools.

Inflation Derivatives Under Inflation Target Regimes

Inflation targeting -- the central bank practice of attempting to keep inflation levels within fixed bounds around a quantitative target -- has been adopted by more than twenty economies. Such practice has an important impact on the stochastic nature of inflation and, consequently, on the pricing of inflation derivatives. We develop a flexible model of inflation targeting in which the central banks intervention to steer inflation towards the target depends on past deviations and the policymakers ability or will to enforce the target. We use our model to price inflation derivatives and demonstrate the impact of inflation targeting on derivative pricing.

Bank Risk Dynamics Where Assets Are Risky Debt Claims

The structural approach views firms equity as a call option on the value of its assets, which motivates stockholders to increase risk. However, since bank assets are risky debt claims, bank equity resembles a subordinated debt. Using this assumption, and considering the strategic interaction between a bank and its debtor, we argue that risk shifting is limited to states in which the debtor is in financial distress. Furthermore, risk shifting increases with bankruptcy costs and decreases with bank capital. Thus, increasing a banks capital affects stability, not only through the additional capital buffer, but also by affecting the risk shifting incentive.

Executive Compensation and Risk Taking: The Impact of Systemic Crises

It is widely accepted that managerial compensation packages contributed to the excessive risk-taking practices that led to the onset of the Great Recession (2007–2009). We argue that the relationship between managerial compensation and risk taking is procyclical. A given level of performance incentives may result in significantly lower firm risk when economy is in a systemic crisis because managers face an increased employment risk during economic downturns. Students of finance who will become policy makers or who will sit on compensation committees would benefit from realizing that in order to implement a given level of firm risk, managerial compensation packages may need to be adjusted according to the state of the economy.