http://www.federalreserve.gov/pubs/workingpapers.htm Staff working papers in the Finance and Economics Discussion Series (FEDS) and International Finance Discussion Papers (IFDPS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the FEDS or IFDPS (other than acknowledgment) should be cleared with the author(s) to protect the tentative character of these papers. http://www.federalreserve.gov/pubs/ifdp/2009/983/default.htm In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound for policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. The duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the liquidity trap, implying more contractionary effects for the home country; conversely, large positive shocks can prompt an early exit, implying effects that are closer to those when the zero bound constraint is not binding. 2009-11-03T12:17:19-04:00 en The Effects of Foreign Shocks When Interest Rates are at Zero 2009-11-03T12:11:33-04:00 FRB Zero lower bound spillover effects DSGE models IFDP983: The Effects of Foreign Shocks When Interest Rates are at Zero http://www.federalreserve.gov/pubs/ifdp/2009/983/ifdp983.pdf PDF version Martin Bodenstein, Christopher J. Erceg, and Luca Guerrieri 2009-11-03T12:11:33-04:00 983 F32 F41 http://www.federalreserve.gov/pubs/ifdp/2009/982/default.htm We introduce a novel method for estimating a monetary policy rule using macroeconomic news. Market forecasts of both economic conditions and monetary policy are affected by news, and our estimation links the two effects. This enables us to estimate directly the policy rule agents use to form their expectations, and in so doing flexibly capture the particular dynamics of policy response. We find evidence that between 1994 and 2007 the market-perceived Federal Reserve policy rule changed: the output response vanished, and the inflation response path became more gradual but larger in long-run magnitude. In a standard model we show that output smoothing caused by a larger inflation response magnitude is offset by the more measured pace of response. Our response coefficient estimates are robust to measurement and theoretical issues with both potential output and the inflation target. 2009-11-03T12:17:19-04:00 en The Market-Perceived Monetary Policy Rule 2009-11-02T10:54:09-04:00 FRB Monetary policy rule market perceptions Taylor Rule Fed funds futures IFDP982: The Market-Perceived Monetary Policy Rule http://www.federalreserve.gov/pubs/ifdp/2009/982/ifdp982.pdf PDF version James D. Hamilton, Seth Pruitt, and Scott C. Borger 2009-11-02T10:54:09-04:00 982 E43 E52 E58 http://www.federalreserve.gov/pubs/ifdp/2009/981/default.htm We study empirical mean-variance optimization when the portfolio weights are restricted to be direct functions of underlying stock characteristics such as value and momentum. The closed-form solution to the portfolio weights estimator shows that the portfolio problem in this case reduces to a mean-variance analysis of assets with returns given by single-characteristic strategies (e.g., momentum or value). In an empirical application to international stock return indexes, we show that the direct approach to estimating portfolio weights clearly beats a naive regression-based approach that models the conditional mean. However, a portfolio based on equal weights of the single-characteristic strategies performs about as well, and sometimes better, than the direct estimation approach, highlighting again the difficulties in beating the equal-weighted case in mean-variance analysis. The empirical results also highlight the potential for `stock-picking' in international indexes, using characteristics such as value and momentum, with the characteristic-based portfolios obtaining Sharpe ratios approximately three times larger than the world market. 2009-11-03T12:17:19-04:00 en Characteristic-Based Mean-Variance Portfolio Choice 2009-11-02T10:51:55-04:00 FRB Mean-variance analysis momentum strategies portfolio choice stock characteristics value strategies IFDP981: Characteristic-Based Mean-Variance Portfolio Choice http://www.federalreserve.gov/pubs/ifdp/2009/981/ifdp981.pdf PDF version Erik Hjalmarsson and Peter Manchev 2009-11-02T10:51:55-04:00 981 C22 C23 G11 G15 http://www.federalreserve.gov/pubs/ifdp/2009/980/default.htm We study the impact that algorithmic trading, computers directly interfacing at high frequency with trading platforms, has had on price discovery and volatility in the foreign exchange market. Our dataset represents a majority of global interdealer trading in three major currency pairs in 2006 and 2007. Importantly, it contains precise observations of the size and the direction of the computer-generated and human-generated trades each minute. The empirical analysis provides several important insights. First, we find evidence that algorithmic trades tend to be correlated, suggesting that the algorithmic strategies used in the market are not as diverse as those used by non-algorithmic traders. Second, we find that, despite the apparent correlation of algorithmic trades, there is no evident causal relationship between algorithmic trading and increased exchange rate volatility. If anything, the presence of more algorithmic trading is associated with lower volatility. Third, we show that even though some algorithmic traders appear to restrict their activity in the minute following macroeconomic data releases, algorithmic traders increase their provision of liquidity over the hour following each release. Fourth, we find that non-algorithmic order flow accounts for a larger share of the variance in exchange rate returns than does algorithmic order flow. Fifth, we find evidence that supports the recent literature that proposes to depart from the prevalent assumption that liquidity providers in limit order books are passive. 2009-11-03T12:17:19-04:00 en Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market 2009-11-02T10:49:12-04:00 FRB Algorithmic trading volatility liquidity provision private information IFDP980: Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market http://www.federalreserve.gov/pubs/ifdp/2009/980/ifdp980.pdf PDF version Alain Chaboud, Benjamin Chiquoine, Erik Hjalmarsson, and Clara Vega 2009-11-02T10:49:12-04:00 980 F3 G12 G14 G15 http://www.federalreserve.gov/pubs/feds/2009/200944/200944abs.html This paper extends the approach of measuring and stress-testing the systemic risk of a banking sector in Huang, Zhou, and Zhu (2009) to identifying various sources of financial instability and to allocating systemic risk to individual financial institutions. The systemic risk measure, defined as the insurance cost to protect against distressed losses in a banking system, is a risk-neutral concept of capital based on publicly available information that can be appropriately aggregated across different subsets. An application of our methodology to a portfolio of twenty-two major banks in Asia and the Pacific illustrates the dynamics of the spillover effects of the global financial crisis to the region. The increase in the perceived systemic risk, particularly after the failure of Lehman Brothers, was mainly driven by the heightened risk aversion and the squeezed liquidity. The analysis on the marginal contribution of individual banks to the systemic risk suggests that ``too-big-to-fail" is a valid concern from a macroprudential perspective of bank regulation. en 2009-11-02T10:05:47-05:00 2009-11-02 10:05:47 Assessing the Systemic Risk of a Heterogeneous Portfolio of Banks During the Recent Financial Crisis Xin Huang Xin Huang Department of Economics, University of Oklahoma Hao Zhou Hao Zhou Risk Analysis Section, Federal Reserve Board Haibin Zhu Haibin Zhu Bank for International Settlements, Asia-Pacific Office Xin Huang, Hao Zhou, and Haibin Zhu 2009-11-02T10:05:47-05:00 Systemic risk macroprudential regulation portfolio distress loss credit default swap dynamic conditional correlation 2009-44 G21 G28 G13 Xin Huang, Hao Zhou, and Haibin Zhu, "Assessing the Systemic Risk of a Heterogeneous Portfolio of Banks During the Recent Financial Crisis," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-44. Washington DC: Federal Reserve, Mon 2-Nov-2009 http://www.federalreserve.gov/pubs/feds/2009/200943/200943abs.html Delinquencies on residential mortgages and home foreclosures have risen dramatically in the past couple of years. The mortgage losses triggered a broad-based financial crisis and severe recession, which, in turn, exacerbated the initial financial distress faced by homeowners. Although servicers increased their loss mitigation efforts as defaults began to mount, foreclosures continued to occur in cases where both the borrower and investor would be better off if such an outcome were avoided. The U.S. government has engaged in a number of initiatives to reduce such foreclosures. This paper examines the economic underpinnings of the Administration's loan modification program, the Home Affordable Modification Program (HAMP). We argue that HAMP should help many borrowers avoid foreclosure, as its key features--a standardized protocol, incentive fees for servicers, and a requirement that the first lien mortgage payment be reduced to 31 percent of gross income--alleviate some of the previous obstacles to successful modifications. That said, HAMP is not well-suited to address payment problems associated with job loss because the required modification in such cases would often be too costly to qualify for the program. In addition, the focus of the program on reducing the payments associated with the mortgage rather than the principal of the mortgage may limit its effectiveness when the homeowner's equity is sufficiently negative. In this case, recent government efforts to establish a protocol for short sales should be a useful tool in avoiding costly foreclosure. en 2009-10-27T18:15:57-05:00 2009-10-27 18:15:57 Designing Loan Modifications to Address the Mortgage Crisis and the Making Home Affordable Program Larry Cordell Larry Cordell Federal Reserve Bank of Philadelphia Karen Dynan Karen Dynan Brookings Institute Andreas Lehnert Andreas Lehnert Board of Governors of the Federal Reserve System Nellie Liang Nellie Liang Board of Governors of the Federal Reserve System Eileen Mauskopf Eileen Mauskopf Board of Governors of the Federal Reserve System Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen Mauskopf 2009-10-27T18:15:57-05:00 Mortgage mortgage-servicers mortgage-modification foreclosures HAMP GSEs 2009-43 G01 G21 G28 H40 H20 H00 H81 Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen Mauskopf, "Designing Loan Modifications to Address the Mortgage Crisis and the Making Home Affordable Program," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-43. Washington DC: Federal Reserve, Tue 27-Oct-2009 http://www.federalreserve.gov/pubs/feds/2009/200941/200941abs.html We explore education's role in improving the allocation of labor between China's agricultural and nonagricultural sectors and measure the portion of China's recent growth attributable to this channel. Building from micro-level estimates, we find that education's impact on labor reallocation between sectors accounts for about 9 percent of Chinese growth, whereas its impact on within-sector human capital growth explains only 2 percent. Our findings suggest that, when frictions cause large productivity gaps across sectors and returns to education are greater in higher-productivity sectors, education policy may be a useful tool for increasing efficiency. en 2009-10-27T09:54:15-05:00 2009-10-27 09:54:15 Education's Role in China's Structural Transformation Soohyung Lee Soohyung Lee University of Maryland and MPRC Benjamin Malin Benjamin Malin Board of Governors of the Federal Reserve System Soohyung Lee and Benjamin A. Malin 2009-10-27T09:54:15-05:00 Returns to education structural transformation China labor reallocation economic growth 2009-41 O1 O5 I2 J6 N3 Soohyung Lee and Benjamin A. Malin, "Education's Role in China's Structural Transformation," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-41. Washington DC: Federal Reserve, Tue 27-Oct-2009 http://www.federalreserve.gov/pubs/feds/2009/200942/200942abs.html Reverse mortgages allow elderly homeowners to tap into their housing wealth without having to sell or move out of their homes. However, very few eligible homeowners have used reverse mortgages to achieve consumption smoothing until recently when the reverse mortgage market in the United States witnessed substantial growth. This paper examines 1989-2007 loan-level reverse mortgage data and presents a number of findings. First, I show that recent reverse mortgage borrowers are significantly different from earlier borrowers in many respects. Second, I find that borrowers who take the line-of-credit payment plan, single male borrowers, and borrowers with higher house values exit their homes sooner than other reverse mortgage borrowers. Third, I combine the reverse mortgage data with county-level house price data to show that elderly homeowners are more likely to purchase reverse mortgages when the local housing market is at its peak. This finding suggests that the 2000-05 housing market boom may be partially responsible for the rapid growth of reverse mortgage markets. Lastly, I show that the Federal Housing Administration (FHA) mortgage limits, which cap the amount of housing wealth that an eligible homeowner can borrow against, have no effect on the demand for reverse mortgages. The findings have important implications to both policy-making and the economics of housing and aging. en 2009-10-19T18:15:08-05:00 2009-10-19 18:15:08 Reversing the Trend: The Recent Expansion of the Reverse Mortgage Market Hui Shan Hui Shan Board of Governors of the Federal Reserve System Hui Shan 2009-10-19T18:15:08-05:00 Reverse mortgages housing aging 2009-42 E21 J14 R21 Hui Shan, "Reversing the Trend: The Recent Expansion of the Reverse Mortgage Market," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-42. Washington DC: Federal Reserve, Mon 19-Oct-2009 http://www.federalreserve.gov/pubs/feds/2009/200940/200940abs.html In this paper I analyze a broad class of continuous-time jump diffusion models of asset returns. In the models, stochastic volatility can arise either from a diffusion part, or a jump part, or both. The jump component includes either compound Poisson or Levy alpha-stable jumps. To be able to estimate the models with latent Levy alpha-stable jumps, I construct a new Markov chain Monte Carlo algorithm. I estimate all model specifications with S&P500 daily returns. I find that models with Levy alpha-stable jumps perform well in capturing return characteristics if diffusion is a source of stochastic volatility. Models with stochastic volatility from jumps and models with Poisson jumps cannot represent excess kurtosis and tails of return distribution. In density forecast and VaR analysis, the model with Levy alpha-stable jumps and joint stochastic volatility performs the best among all other specifications, since both diffusion and infinite activity jump part provide information about latent volatility. en 2009-10-14T16:28:47-05:00 2009-10-14 16:28:47 Bayesian Analysis of Stochastic Volatility Models with Levy Jumps: Application to Risk Analysis Pawel Szerszen Pawel Szerszen Board of Governors of the Federal Reserve System Pawel J. Szerszen 2009-10-14T16:28:47-05:00 Bayesian estimation stochastic volatility Levy Jumps density forecast 2009-40 C1 C11 G1 G12 Pawel J. Szerszen, "Bayesian Analysis of Stochastic Volatility Models with Levy Jumps: Application to Risk Analysis," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-40. Washington DC: Federal Reserve, Wed 14-Oct-2009 http://www.federalreserve.gov/pubs/feds/2009/200939/200939abs.html Using a proprietary dataset of credit bureau records, Cohen-Cole (2008) finds that banks set credit limits on revolving accounts based in part on the racial composition of the neighborhood in which each borrower resides. This paper evaluates the evidence presented in that working paper using the same proprietary database of credit bureau records. The replication effort presented in this paper suggests that decisions about how to calculate the variables used in that study may have resulted in the unnecessary exclusion of one-fifth of available observations from the estimation samples and may have increased the size of the reported effect by over 25 percent. Furthermore, this analysis suggests that when a control for neighborhood income is added to the estimations, the results presented as evidence of redlining activities disappear. en 2009-10-14T16:28:34-05:00 2009-10-14 16:28:34 Credit Card Redlining Revisited Kenneth Brevoort Kenneth Brevoort Board of Governors of the Federal Reserve System Kenneth P. Brevoort 2009-10-14T16:28:34-05:00 Credit cards redlining racial disparities discrimination 2009-39 J15 G21 Kenneth P. Brevoort, "Credit Card Redlining Revisited," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-39. Washington DC: Federal Reserve, Wed 14-Oct-2009 http://www.federalreserve.gov/pubs/feds/2009/200938/200938abs.html The physical process of aging means that the use of health services varies significantly by age. This association between age and health care consumption raises a number of issues related to intergenerational and intragenerational equity, including the allocation of societal resources across age groups and the effects of population aging and health cost growth on public sector health care burdens and, hence, on intergenerational redistribution. This working paper (forthcoming as a chapter in the Oxford Handbook of Health Economics) provides a detailed look at the theoretical and empirical relationships between health spending and age, both in the US and internationally, and reviews the evidence on the intergenerational redistribution associated with public health spending over time. en 2009-10-14T16:28:24-05:00 2009-10-14 16:28:24 Intergenerational Aspects of Health Care Louise Sheiner Louise Sheiner Board of Governors of the Federal Reserve System Louise Sheiner 2009-10-14T16:28:24-05:00 Health demographics 2009-38 I1 Louise Sheiner, "Intergenerational Aspects of Health Care," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-38. Washington DC: Federal Reserve, Wed 14-Oct-2009 http://www.federalreserve.gov/pubs/ifdp/2009/979/default.htm Among the various explanations for the runup in oil and commodity prices of recent years, one story focuses on the role of monetary policy in the United States and in developing economies. In this view, developing countries that peg their currencies to the dollar were forced to ease their monetary policies after reductions in U.S. interest rates, leading to economic overheating, excess demand for oil and other commodities, and rising commodity prices. We assess that hypothesis using the Federal Reserve staffs forward-looking, multicountry, dynamic general equilibrium model, SIGMA. We find that even if many developing country currencies were pegged to the dollar, an easing of U.S. monetary policy would lead to only a transitory runup in oil prices. Instead, strong economic growth in many developing economies, as well as shortfalls in oil production, better explain the sustained runup in oil prices observed until earlier this year. Moreover, a closer look at exchange rates and interest rates around the world suggests that the monetary policies of many developing economies, including in East Asia, are less closely influenced by U.S. policies than is frequently assumed. 2009-11-03T12:17:19-04:00 en Did Easy Money in the Dollar Bloc Fuel the Global Commodity Boom? 2009-10-09T9:31:50-04:00 FRB Oil prices SDGE models monetary policy IFDP979: Did Easy Money in the Dollar Bloc Fuel the Global Commodity Boom? http://www.federalreserve.gov/pubs/ifdp/2009/979/ifdp979.pdf PDF version Christopher Erceg, Luca Guerrieri, and Steven B. Kamin 2009-10-09T9:31:50-04:00 979 F41 F42 http://www.federalreserve.gov/pubs/feds/2009/200937/200937abs.html In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro-macro model, takes into account dynamic linkages between the health of major U.S. banks and macrofinancial conditions. Our results suggest that the theoretical insurance premium that would be charged to protect against losses that equal or exceed 15 percent of total liabilities of 12 major U.S. financial firms stood at $110 billion in March 2008 and had a projected upper bound of $250 billion in July 2008. en 2009-09-17T16:41:02-05:00 2009-09-17 16:41:02 A Framework for Assessing the Systemic Risk of Major Financial Institutions Xin Huang Xin Huang Department of Economics, University of Oklahoma Hao Zhou Hao Zhou Risk Analysis Section, Federal Reserve Board Haibin Zhu Haibin Zhu Bank for International Settlements, Asia-Pacific Office Xin Huang, Hao Zhou, and Haibin Zhu 2009-09-17T16:41:02-05:00 Systemic risk stress testing portfolio credit risk credit default swap high-frequency data 2009-37 G21 G28 G14 C13 Xin Huang, Hao Zhou, and Haibin Zhu, "A Framework for Assessing the Systemic Risk of Major Financial Institutions," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-37. Washington DC: Federal Reserve, Thu 17-Sep-2009 http://www.federalreserve.gov/pubs/feds/2009/200936/200936abs.html The $350 billion contraction in the asset-backed commercial paper (ABCP) market in the last five months of 2007 played a central role in transforming concerns about the credit quality of mortgage-related assets into a global financial crisis. This paper attempts to better understand why the substantial contraction in ABCP occurred by measuring and analyzing runs on ABCP programs over the period from August 2007 through December 2007. While it has been suggested that commercial paper programs, like commercial banks, may be prone to runs, we are the first to conduct a comprehensive empirical analysis of runs in the ABCP market using a rich and novel issue-level data set for all ABCP programs in the U.S. market. A program is defined as being run when it does not issue new paper during a week despite having a substantial share of its outstandings scheduled to mature, and then continuing in a run until it issues. We find evidence of extensive runs: more than 100 programs (one-third of all ABCP programs) were in a run within weeks of the onset of the turmoil and the odds of subsequently leaving the run state were very low. We interpret this finding as an indication that the ABCP market was subject to a bank-like "panic." We also find that while runs were linked to credit and liquidity exposures of individual programs, runs were also related importantly to non-program specific variables in the first several weeks of the turmoil, indicating that runs were relatively indiscriminate during the early part of the panic. Thus the ABCP market may be inherently unstable and a source of systemic risk. en 2009-09-14T14:10:44-05:00 2009-09-14 14:10:44 The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market Daniel Covitz Daniel Covitz Board of Governors of the Federal Reserve System Nellie Liang Nellie Liang Board of Governors of the Federal Reserve System Gustavo Suarez Gustavo Suarez Board of Governors of the Federal Reserve System Daniel M. Covitz, Nellie Liang, and Gustavo A. Suarez 2009-09-14T14:10:44-05:00 Commercial paper asset-backed commercial paper bank runs financial crisis panics 2009-36 G01 G10 G21 Daniel M. Covitz, Nellie Liang, and Gustavo A. Suarez, "The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market," Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2009-36. Washington DC: Federal Reserve, Mon 14-Sep-2009 http://www.federalreserve.gov/pubs/ifdp/2009/977/default.htm We decompose the returns differential between U.S. portfolio claims and liabilities into the composition, return, and timing effects. Our most striking and robust finding is that foreigners exhibit poor timing when reallocating between bonds and equities within their U.S. portfolios. The poor timing of foreign investors--caused primarily by deliberate trading, not a lack of portfolio rebalancing--contributes positively to the U.S. external returns differential. We find no evidence that the poor timing is driven by mechanical reserve accumulation by emerging market countries; rather, it is driven almost entirely by the poor timing of rich, developed (mainly European) countries. Finally, while poor foreign timing appears to be persistent across subsamples, other terms in our decomposition (the composition and return effects and U.S. timing abroad), as well as the overall differential, are sometimes negative, sometimes positive, and usually indistinguishable from zero. 2009-11-03T12:17:19-04:00 en Decomposing the U.S. External Returns Differential 2009-09-10T9:42:46-04:00 FRB Returns differential timing effect IFDP977: Decomposing the U.S. External Returns Differential http://www.federalreserve.gov/pubs/ifdp/2009/977/ifdp977.pdf PDF version Stephanie Curcuru, Tomas Dvorak, and Francis E. Warnock 2009-09-10T9:42:46-04:00 977 F21 F3