Burkhard Drees

The Nordic Banking Crises: Pitfalls in Financial Liberalization?

This study examines the banking crises in Finland, Norway and Sweden, which took place in the early 1990s, and draws some policy conclusions from their experiences. One key conclusion is that factors in addition to business cycle effects explain the Nordic countries financial problems. Although the timing of the deregulation in all three countries coincided with a strongly expansionary macroeconomic momentum, the main reasons for the banking crises were the delayed policy responses, the structural characteristics of the financial systems, and the banks inadequate internal risk-management controls.

Welfare Effects of Transparency in Foreign Exchange Markets: The Role of Hedging Opportunities

The paper studies the impact of more transparency on the risk-sharing opportunities in the foreign exchange market and the associated implications on ex ante welfare. Transparency is measured in this model by the informational content of publicly observable signals about exchange rate developments. The authors find that in this model more transparency improves welfare in economies that are poorly endowed with capital and/or where investors are not very risk-averse, while welfare is reduced in economies with large capital endowments and/or where investors are highly risk-averse.

The Nordic Banking Crisis : Pitfalls in Financial Liberalization: Pitfalls in Financial Liberalization

This study examines the banking crises in Finland, Norway and Sweden, which took place in the early 1990s, and draws some policy conclusions from their experiences. One key conclusion is that factors in addition to business cycle effects explain the Nordic countries financial problems. Although the timing of the deregulation in all three countries coincided with a strongly expansionary macroeconomic momentum, the main reasons for the banking crises were the delayed policy responses, the structural characteristics of the financial systems, and the banks inadequate internal risk-management controls.

Cheap Money and Risk Taking: Opacity versus Fundamental Risk

We explore the effect of interest rates on risk taking and find that it depends on the type of risk involved. In a Bayesian setting, investments can be risky either because payoff-relevant signals are noisy or because the dispersion of the prior is high. While both types of risk contribute symmetrically to the overall riskiness of an investment project, we show that changes in interest rates affect risk taking in these two types of risk in opposite directions. This makes the net effect of interest rates on risk taking—as measured by the average riskiness of financed projects—necessarily ambiguous and dependent on the sources of risk.

Asset Mispricing Due to Cognitive Dissonance

The behavior of equity prices is analyzed in a general equilibrium model where agents have preferences not only over consumption but also (implicitly) over their beliefs. To alleviate cognitive dissonance, investors endogenously choose to ignore information that conflicts too much with their ex ante expectations. Depending on the new information that is released, systematic overvaluation and undervaluation of equity prices arise, as well as too much and too little equity price volatility. The distortion in the asset pricing process is closely related to the precision of the information.

The Risk and Price Volatility of Stock Options in General Equilibrium

The traditional valuation formulas for options were derived in a complete market setting and were based on the no-arbitrage principle. If the asset structure is incomplete, the presence of options affects the linear subspace spanned by the payoffs of the existing assets, and the pricing of options and underlying primary assets becomes a simultaneous valuation problem. We characterize the relationship between the prices of options and the prices of the stocks on which the options are written in a general equilibrium model where options are non-redundant assets. Contrary to the predictions of the Black-Scholes-Merton theory, in our model investor preferences have an impact on the relationship between the prices of primary and derivative assets. Copyright 1995 by The editors of the Scandinavian Journal of Economics.

Leverage and the price volatility of equity shares in equilibrium

The traditional valuation formulas for corporate debt, which are derived in a complete market setting and are based on the no-arbitrage principle, imply that equity prices become more volatile as leverage increases. If the asset structure is incomplete, the presence of corporate debt affects the linear subspace spanned by the payoffs of the existing assets, and the pricing of corporate debt and shares of levered firms becomes a simultaneous valuation problem. This paper characterizes the relationship between the price of corporate debt and the share price of a levered firm in an equilibrium framework where corporate debt is a non-redundant asset. While, in the absence of bankruptcy, higher leverage always implies riskier equity, it does not necessarily mean more volatile equity prices. In fact, the link between leverage and equity price volatility depends in a particular way on investors’ preferences towards risk.

The composition of stock price indices and the excess volatility puzzle

Abstract In the framework of a simple consumption-based asset pricing model this paper characterizes classes of investor preferences for which the omission or underrepresentation of high risk assets (resp. low risk assets) in a stock index increases the price volatility of the index. Since empirical variance bounds tests use common stock indices which consist of only a subset of all assets, our result may have important implications for the correct interpretation of the alleged excessive volatility of stock prices.

Information and the dispersion of posterior expectations

We explore the intuitive idea that more information leads to greater dispersion of posterior beliefs about the expected state of the world. First, we show that two dispersion orders that have been widely used as informativeness criteria do not satisfy the desirable property of ordinality of states (OS), i.e., invariance to increasing monotone state transformations. Then, for the class of monotone information systems, we characterize the weakest information criteria that respect OS and imply the dispersion orders. Our characterizations consist of intuitive conditions on the joint distributions of signals and states. Because of OS, the information criteria induce the dispersion orders not only on the posterior expectations of states, but also of state utilities, under any strictly increasing vNM utility function.

Price volatility and risk with non-separability of preferences

This paper studies the relationship between the systematic risk of financial instruments and the volatility of their equilibrium prices in a two-period stochastic asset valuation model. Whereas there is no link between the relative risk of assets and their price volatility in standard representative-agent models with additively-separable preferences, in this model with non-separable preferences a riskier asset can have higher or lower price volatility than a safe asset depending on the intertemporal changes in risk aversion. If individual preferences exhibit risk substitutability (i.e. future relative risk aversion decreases with higher current consumption), then the riskier asset has a more volatile price than the less risky asset. Agents’ risk complementarity (i.e. increasing future relative risk aversion with higher current consumption), on the other hand, implies an inverse relationship between the relative riskiness of assets and the volatility of their prices.