Zvi Bodie

On the Management of Financial Guarantees

Financial guarantees, such as insurance against credit risk and contract default, serve an important function for virtually every player in the global economy - households, businesses, and governments. Without such guarantees, both implicit and explicit, many economic activities would be less efficiently performed. This paper develops a framework for analyzing the efficient management of such guarantees in both the private and public sectors.

The Global Financial System: A Functional Perspective

Leading financial scholars present essays examining the performance of the basic financial functions underlying global financial systems: payments, lending and investing, pooling funds, allocating risk, providing information, and dealing with incentive issues - with particular emphasis on how their performance is changing and implications for the future.

Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan?

This paper examines the empirical question of whether systematic equity risk of U.S. firms as measured by beta from the Capital Asset Pricing Model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet, and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of Pension Benefit Guaranty Corporation further clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firms pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment will typically bias upwards estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known U.S. companies. This bias can result in positive net-present-value projects being rejected.

Optimal consumption-portfolio choices and retirement planning

Abstract We examine consumption and investment decisions in a life-cycle model with habit formation, stochastic opportunity set, stochastic wages and labor supply flexibility. Retirement is taken into account by specifying an age at which labor earnings stop, but consumption spending continues. Explicit solutions are obtained for optimal consumption, labor supply and the financing portfolio. We examine the structure and determinants of the optimal portfolio. We also study the effects of the retirement date and of habits on optimal decisions. Finally, we conduct a preliminary analysis to assess the effects of a liquidity constraint on optimal consumption–leisure choices.

Deposit insurance reform: a functional approach

Abstract The current system of deposit insurance has a basic structural problem because there is a mismatch between the deposits insured by the FDIC and the “opaque” and illiquid bank loans used to collateralize those insured deposits. There may have been, at one time, synergy created by using insured deposits as the primary source to finance the commercial lensing activities of banks, but we see no evidence that such benefits, if any, exist in todays financial system. There are, however, significant costs for maintining the current institutional structure. We conclude that an efficient solution is for commercial lending to be financed by standard instruments such as debt, preferred stock, and equity, and that deposit with U.S. Treasury bills or their equivalent.

A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy

The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy. CCA provides a natural framework for analysis of mismatches between an entitys assets and liabilities, such as currency and maturity mismatches on balance sheets. Policies or actions that reduce these mismatches will help reduce risk and vulnerability. It also provides a new framework for sovereign capital structure analysis. It is useful for assessing vulnerability, policy analysis, risk management, investment analysis, and design of risk control strategies. Both public and private sector participants can benefit from pursuing ways to facilitate more efficient macro risk accounting, improve price and volatility discovery, and expand international risk intermediation activities.

International Pension Swaps

During the past twenty years, swap contracts have become key financial “adapters” linking diverse national financial systems to the global financial network. Today banks and investment companies around the world use swaps extensively to manage their currency, interest-rate, and equity-market risks and to lower their transaction costs. Yet pension funds, which have grown rapidly over that same 20-year period, hardly use swaps at all. This paper suggests how pension funds could use swaps to achieve the risksharing benefits of broad international diversification and hedging while avoiding the “flight” of scarce domestic capital to other countries. The paper also shows how swaps can be used to lower the risks of expropriation and to lower the other transaction costs of investing in other countries.

Interest Rate Uncertainty and the Value of Bond Call Protection

This paper uses a model of the valuation of bonds bearing call options, together with observed market yields on callable bonds, to infer information about the uncertainty associated with interest rate expectations. A dynamic programming solution of the model simultaneously determines both the bond price and the issuers optimal refunding strategy, given the relevant data describing the bond and the markets expectations of future interest rates. Application of the valuation model in reverse, for quarterly average data for 1969-76, generates a time series representing the uncertainty which the market associated with its expectations of future interest rates during this interval, given the then-prevailing yields on new issues of utility bonds and industrial bonds callable after 5 years and 10 years, respectively. This uncertainty, parameterized as the standard deviation of a truncated normal distribution, fluctuated between 1/2 percent and 3/4 percent between 1969 and early 1974, then rose to sharply higher levels from mid-1974 through mid-1975, and has fluctuated between 3/4 percent and 1 percent since late 1975.

Securing employer-based pensions : an international perspective

As the worlds population ages, millions will rely on their pension plans as the mainstay of retirement income. This book asks whether supply will meet demand in the new economic order. Pension systems in Germany, Japan, Canada, and the U.S. are compared, along with those in many developing nations. This volume is intended for employees and managers, pension policymakers, actuaries and lawyers, and benefits consultants, all of whom are busy changing their pension structures to meet global challenges. Sensible tax, insurance, and funding policies-as well as investment management and actuarial oversight-are central to building and maintaining a successful public and private pension system. Tracing the interaction of these factors across a variety of environments, Securing Employer-Based Pensions explores the immediate need for increased pension security in retirement systems in both developed and developing nations.

The Theory of Life-Cycle Saving and Investing

How much should a family save for retirement and for the kids’ college education? How much insurance should they buy? How should they allocate their portfolio across different assets? What should a company choose as the default asset allocation for a mandatory retirement saving plan? We believe that the life-cycle model developed by economists over the last fifty years provides guidance for making such decisions. The theory teaches us to view financial assets as vehicles for transferring resources across different times and outcomes over the life cycle, and that perspective allows households and planners to think about their decisions in a logical and rigorous way. This paper lays out and illustrates the basic analytical framework from the theory in nonmathematical terms, with the aim of providing guidance to financial service providers, consumers, and policymakers.