Board of Governors of the Federal Reserve System

Abstract:

As successive rounds of global trade liberalization have lowered broad industry-level tariffs, antidumping duties have emerged as a WTO-consistent means of protecting certain industries. Using the Grossman-Helpman (GH) "Protection for Sale" model, we examine the extent to which political contributions affect the outcomes of decisions in antidumping cases. We find that antidumping duty rates tend to be higher for politically-active petitioners. The relationship between the import penetration ratio and duties imposed depends on whether or not petitioners in a case are politically active. Consistent with the predictions of the GH model, antidumping duties are positively correlated with the import penetration ratio for politically inactive petitioners, but negatively correlated for politically active petitioners. Thus, our paper supports the predictions of the Grossman-Helpman model using a fresh set of data that allows us to avoid some of the compromises made in previous empirical work.

Keywords: Trade policy, Antidumping, Political economy

Abstract:

This paper updates our earlier work (Ahearne, Fernald, Loungani and Schindler, 2003) on whether China, with its huge pool of labor and an allegedly undervalued exchange rate, is hurting the export performance of other emerging market economies in Asia. We continue to find that while exchange rates matter for export performance, the income growth of trading partners matters far more. This suggests the potential for exports of all Asian economies to grow in harmony as long as global growth is strong. We also examine changes in export shares of Asian economies to the U.S. market and find evidence that dramatic changes in shares are taking place. Many of these changes are consistent with a 'flying geese' pattern in which China moves into the product space vacated by the Asian NIEs or with greater integration of trade across Asia in the production of final goods. Nevertheless, China's dramatic gains in recent years do increase the pressure on Asian economies, particularly in ASEAN and South Asia, to seek areas of comparative advantage.

Keywords: Exports, trade links, exchange rates, trade equations

Abstract:

This paper documents the impact of U.S. monetary policy announcement surprises on foreign equity indexes, short- and long-term interest rates, and exchange rates in 49 countries. We use two proxies for monetary policy surprises: the surprise change to the current target federal funds rate (target surprise) and the revision to the path of future monetary policy (path surprise). We find that different asset classes respond to different components of the monetary policy surprises. Global equity indexes respond mainly to the target surprise; exchange rates and long-term interest rates respond mainly to the path surprise; and short-term interest rates respond to both surprises. On average, a hypothetical surprise 25-basis-point cut in the federal funds target rate is associated with about a 1 percent increase in foreign equity indexes and a 5 basis point decline in foreign short-term interest rates. A surprise 25-basis-point downward revision in the path of future policy is associated with about a percent decline in the exchange value of the dollar against foreign currencies and 5 and 8 basis points declines in short- and long-term interest rates, respectively. We also find that asset prices' responses to FOMC announcements vary greatly across countries, and that these cross-country variations in the response are related to a country's exchange rate regime. Equity indexes and interest rates in countries with a less flexible exchange rate regime respond more to U.S. monetary policy surprises. In addition, the cross-country variation in the equity market response is strongly related to the percentage of each country's equity market capitalization owned by U.S. investors (a financial linkage), and the cross-country variation in short-term interest rates' responses is strongly related to the share of each country's trade that is with the United States (a real linkage).

Keywords: Monetary policy announcements, equity markets, interest rates, exchange rates, exchange rate regime

Abstract:

We argue that there are conditions such that any inflation targeting regime is preferable to full policy discretion, even if long-run inflation rates are identical across regimes. The key observation is that strict inflation targeting outperforms the discretionary policy response to sufficiently persistent shocks. Under full policy discretion, inflation expectations over the medium term respond to the shock and thereby amplify its impact on output. As a result, little output stabilization is achieved at the cost of large and persistent inflation fluctuations.

Keywords: Monetary policy, inflation targeting, rules versus discretion

Abstract:

The real exchange rate is very volatile relative to major macroeconomic aggregates and its correlation with the ratio of domestic over foreign consumption is negative (Backus-Smith puzzle). These two observations constitute a puzzle to standard international macroeconomic theory. This paper develops a two country model with complete asset markets and limited enforcement for international financial contracts that provides a possible explanation of these two puzzles. The model performs better than a standard incomplete markets model with a single non-contingent bond unless very tight borrowing constraints are imposed in the latter. With limited enforcement for both domestic and international financial contracts, the model's asset pricing implications are brought into line with the empirical evidence, albeit at the expense of raising real exchange rate volatility.

Keywords: Risk-sharing, limited enforcement, real exchange rate, Backus-Smith puzzle, asset prices

Abstract:

We focus on capturing the increasingly important role that emerging economies play in determining U.S. import prices. Emerging market producers differ from others in two respects: (1) their cost structure is well below that of developed-market producers, and (2) their wide profit margins induce pricing policies that seek to exhaust production capacity. We argue that these features have dampened the short-run responses of import prices to changes in the value of the dollar but that they have not altered the associated long-run response. To capture these considerations, we develop a new method to measure foreign prices and adopt a formulation that differentiates between short- and long-run responses. Our econometric work asks two questions: First, can one replicate the literature's dispersion of pass-through estimates? Second, is there any evidence of a change in the dynamic response of import prices to changes in the exchange value of the dollar? To address the first question, we estimate the parameters of our models using several alternative measures of U.S. and foreign prices, dynamic specifications, and sample periods. We find that these alternative inputs translate into a large range of parameter estimates, a finding that helps to rationalizing the existing dispersion of estimates. To address the second question, we compute the implied dynamic adjustment of import prices to a change in the value of the dollar using parameters estimated from two samples: 1974-2000 and 1974-2005. The long-run response of import prices is similar regardless of which sample is used---roughly one-half of the change in the exchange rate is passed through to import prices. However, the short-run response is quite sensitive to the sample period. Specifically, the short-run response based on data through 2005 is smaller than the short-run response based on data through 2000. We argue that one force behind the change in dynamics of the import-price process is the greater presence of producers from emerging economies and that their effect on import prices can be captured with their measure of foreign prices.

Keywords: Aggregation methods, automated specification, exchange rates, pass-through, Penn World Tables

Abstract:

Many economic models featuring labor supply decision, especially in macroeconomic analysis, assume away heterogeneity in the nature of work, or assume that the nature of work is irrelevant to the labor/leisure choice. This paper studies the macroeconomic implications of relaxing this assumption. Estimation from micro data using labor hours, wages, consumption, and nonpecuniary job characteristics suggests that labor supply responds to differences and to changes in the nature of work. Ceteris paribus, some job characteristics induce more labor hours than others do. Labeling the jobs that embed the labor-inducing characteristics as better quality jobs, the study estimates a Job Quality index for the aggregate U.S. economy from 1850 to 2000. The results suggest that over the same period, improvements in Job Quality accounted for at least 20.4 percent of growth in labor hours.

Keywords: Job Quality, Labor Supply, Trends in Labor Hours

Abstract:

This paper considers the prediction of large depreciations (both nominal and real) in a panel of industrialized countries using a probit methodology. The current account balance/GDP ratio has a modest but statistically significant effect on the estimated probability of a large depreciation, and gives slight predictive power in an out-of-sample forecasting exercise. The CPI inflation rate also has a modest but statistically significant effect in predicting nominal depreciations and has slight predictive power, but this effect is not present for real exchange rates. The GDP growth rate occasionally has a significant effect. A higher current account balance (surplus) tends to reduce the probability of a sharp depreciation; a higher inflation rate tends to increase the probability of a sharp depreciation; and a higher GDP growth rate perhaps tends to reduce the probability of a sharp depreciation.

Keywords: Current account, forecasting

Abstract:

We study optimal fiscal and monetary policy in an environment where explicit frictions give rise to valued money, making money essential in the sense that it expands the set of feasible trades. Our main results are in stark contrast to the prescriptions of earlier flexible-price Ramsey models. Two especially important findings emerge from our work: the Friedman Rule is typically not optimal and inflation is stable over time. Inflation is not a substitute instrument for a missing tax, as is sometimes the case in standard Ramsey models. Rather, the inflation tax is exactly the right tax to use because the use of money has a rent associated with it. Regarding the optimal dynamic policy, realized (ex-post) inflation is quite stable over time, in contrast to the very volatile ex-post inflation rates that arise in standard flexible-price Ramsey models. We also find that because capital is underaccumulated, optimal policy includes a subsidy on capital income. Taken together, these findings turn conventional wisdom from traditional Ramsey monetary models on its head.

Keywords: Micro-founded models of money, Friedman Rule, inflation stability

Abstract:

We test for efficiency in the market for Swedish co-ops by examining the negative relationship between the sales price and the present value of future monthly payments or `rents'. If the co-op housing market is efficient, the present value of co-op rental payments due to underlying debt obligations of the cooperative should be fully reflected in the sales price. However, we find that, on average, a one hundred kronor increase in the present value of future rents only leads to an approximately 75 kronor reduction in the sales price; co-ops with higher rents are thus relatively overpriced compared to those with lower rents. We also find that these inefficiencies are larger at the lower end of the housing market and in poorer, less educated regions (though they are still observed in all geographic regions). These findings appear to reflect both the role played by liquidity constraints in price formation and there being more informed and `sophisticated' buyers in higher educated areas who push prices closer to efficiency. Overall, our findings suggest that there is some systematic failure to properly discount the future stream of rent payments relative to the up front sales price.

Keywords: Housing markets, market efficiency, cooperative housing

Abstract:

We argue that, through its effect on aggregate demand and country risk premia, sovereign debt restructuring can adversely affect the private sector's access to foreign capital markets. Using fixed effect analysis, we estimate that sovereign debt rescheduling episodes are indeed systematically accompanied by a decline in foreign credit to emerging market private firms, both during debt renegotiations and for over two years after the agreements are reached. This decline is large (over 20%), statistically significant, and robust when we control for a host of fundamentals. We find that this effect is different for financial sector firms, for exporters, and for nonfinancial firms in the nonexporting sector. We also find that the effect depends on the type of debt rescheduling agreement.

Keywords: Sovereign debt, default, credit rationing, credit constraints

Abstract:

We examine a primary outcome of corporate governance, the ability to identify and terminate poorly performing CEOs, to test the effectiveness of U.S. investor protections in improving the corporate governance of cross-listed firms. We find that firms from weak investor protection regimes that are cross-listed on a major U.S. exchange are more likely to terminate poorly performing CEOs than non-cross-listed firms. Cross-listings on exchanges that do not require the adoption of the most stringent investor protections (OTC, private placements and London listings) are not associated with a higher propensity to shed poorly performing CEOs. Overall, our results provide direct support for the bonding hypothesis of Coffee (1999) and Stulz (1999), and suggest that the functional convergence of legal systems is indeed possible.

Keywords: Bonding hypothesis, CEO turnover, International cross listing, Corporate governance, Functional convergence

Abstract:

I establish stylized empirical facts about the trading behavior of New York Stock Exchange specialists. Specifically, I look at the effect of future price movements, the specialist's explicit role, and the specialist's inventory levels on specialist trading behavior. The motivation for this empirical study is to infer whether the specialist behaves like an active investor who has an information advantage which he obtains while acting as a broker for other traders. If this were the case, one would expect that the specialist would engage in a profit maximizing strategy, buying low and selling high, which is opposite to the prediction of the traditional inventory model. I find that specialists behave like active investors who seek to buy stocks when prices are low and to sell when prices are high. I also find that when specialists are not performing their trading obligations of being on the opposite side of the market they are in almost 85 percent of their trades, buying low and selling high. The findings of this paper indicate that the NYSE specialist is best represented in theoretical models as a constrained profit maximizing, informed investor rather than as a zero profit trader.

Keywords: Market microstructure, Specialist, NYSE, Market maker

Abstract:

This paper studies when and by how much the Fed and the ECB change their target interest rates. I develop a new nonlinear bivariate framework, which allows for elaborate dynamics and potential interdependence between the two countries, as opposed to linear feedback rules, such as a Taylor rule, and I use a novel real-time data set. A Bayesian estimation approach is particularly well suited to the small data sample. Empirical results support synchronization between the central banks and non-zero correlation between mag- nitude shocks, but they do not support follower behavior. Institutional factors and inflation represent relevant variables for timing decisions of both banks. Inflation rates are important factors for magnitude decisions, while output plays a major role in US magnitude decisions.

Keywords: Monetary Policy, Copula, Hazard Probability, Bivariate Probit Models

Abstract:

We study the role played by private and public information in the process of price formation in the U.S. Treasury bond market. To guide our analysis, we develop a parsimonious model of speculative trading in the presence of two realistic market frictions -- information heterogeneity and imperfect competition among informed traders -- and a public signal. We test its equilibrium implications by analyzing the response of two-year, five-year, and ten-year U.S. bond yields to order flow and real-time U.S. macroeconomic news. We find strong evidence of informational effects in the U.S. Treasury bond market: unanticipated order flow has a significant and permanent impact on daily bond yield changes during both announcement and non-announcement days. Our analysis further shows that, consistent with our stylized model, the contemporaneous correlation between order flow and yield changes is higher when the dispersion of beliefs among market participants is high and public announcements are noisy.

Keywords: Treasury Bond Markets, Macroeconomic News Announcements, Strategic Trading, Market Microstructure, Order Flow, Real-Time Data, Expectations, Dispersion of Beliefs

Abstract:

An equilibrium model is used to assess the quantitative importance of monetary policy for the post-1984 decline in U.S. inflation and output volatility. The principal finding is that monetary policy played a substantial role in reducing inflation volatility, but a small role in reducing real output volatility. The model attributes much of the decline in real output volatility to smaller TFP shocks. We also investigate the pattern of output and inflation volatility under an optimal monetary policy counterfactual. We find that real output volatility would have been somewhat lower, and inflation volatility substantially lower, had monetary policy been set optimally.

Keywords: Business cycles, optimal monetary policy

Abstract:

Existing studies using low-frequency data have found that macroeconomic shocks contribute little to international stock market covariation. However, these papers have not accounted for the presence of asymmetric information where sophisticated investors generate private information about the fundamentals that drive returns in many countries. In this paper, we use a new microstructure data set to better identify the effects of private and public information shocks about U.S. interest rates and equity returns. High-frequency private and public information shocks help forecast domestic money and equity returns over daily and weekly intervals. In addition, these shocks are components of factors that are priced in a model of the cross section of international returns. Linking private information to U.S. macroeconomic factors is useful for many domestic and international asset pricing tests.

Keywords: Private Information, International Equity Returns, Monetary Policy, Foreign Exchange Rates, Exchange Traded Funds

Abstract:

Using a unique high-frequency futures dataset, we characterize the response of U.S., German and British stock, bond and foreign exchange markets to real-time U.S. macroeconomic news. We find that news produces conditional mean jumps; hence high-frequency stock, bond and exchange rate dynamics are linked to fundamentals. Equity markets, moreover, react differently to news depending on the stage of the business cycle, which explains the low correlation between stock and bond returns when averaged over the cycle. Hence our results qualify earlier work suggesting that bond markets react most strongly to macroeconomic news; in particular, when conditioning on the state of the economy, the equity and foreign exchange markets appear equally responsive. Finally, we also document important contemporaneous links across all markets and countries, even after controlling for the effects of macroeconomic news.

Keywords: Asset Pricing, Macroeconomic News Announcements, Financial Market Linkages, Market Microstructure, High-Frequency Data, Survey Data, Asset Return Volatility, Forecasting

Abstract:

Heterogeneity between unemployed and employed individuals matters for optimal fiscal policy. This paper considers the consequences of welfare heterogeneity between these two groups for the determination of optimal capital and labor income taxes in a model with matching frictions in the labor market. In line with a recent finding in the literature, we find that the optimal capital tax is typically non-zero because it is used to indirectly mitigate an externality along the extensive labor margin that arises from search and matching frictions. However, the consideration of heterogeneity makes our result differ in an important way: even for a well-known parameter configuration (the Hosios condition) that typically eliminates this externality, we show that the optimal capital income tax is still non-zero. We also show that labor adjustment along the intensive margin has an important effect on efficiency at the extensive margin, and hence on the optimal capital tax, independent of welfare heterogeneity. Taken together, our results show that these two empirically-relevant features of the labor market can have a quantitatively-important effect on the optimal capital tax.

Keywords: Optimal fiscal policy, labor search, Hosios condition

Abstract:

This paper analyzes panel data inference in predictive regressions with endogenous and nearly persistent regressors. The standard fixed effects estimator is shown to suffer from a second order bias; analytical results, as well as Monte Carlo evidence, show that the bias and resulting size distortions can be severe. New estimators, based on recursive demeaning as well as direct bias correction, are proposed and methods for dealing with cross sectional dependence in the form of common factors are also developed. Overall, the results show that the econometric issues associated with predictive regressions when using time-series data to a large extent also carry over to the panel case. However, practical solutions are more readily available when using panel data. The results are illustrated with an application to predictability in international stock indices.

Keywords: Cross-sectional dependence, Panel data, Pooled regression, Predictive regression, Stock return predictability

Abstract:

This paper provides a robust structural identification of the effects of U.S. interest rates on an emerging economy's asset values. Using newly available intraday data, we investigate how surprises associated with U.S. macro data and FOMC announcements move the yield spread on a benchmark Brazilian government dollar-denominated bond and the Brazilian broad stock price index. Our study covers the period February 1999 to April 2005. We find that FOMC announcements that lead to an increase in U.S. interest rates are associated with a systematic increase in Brazil's bond spread and a systematic decline in the stock price index. Several U.S. macro data surprises, including for nonfarm payrolls and the CPI, prompt an increase in the Brazilian bond yield spread and a fall in Brazilian share prices. These combined findings suggest that, for Brazil during this period, the financial risks of higher U.S. interest rates in response to positive news about the U.S. economy dominated any benefits through trade or other channels in the determination of Brazilian asset valuations.

Keywords: Data releases, monetary policy, emerging markets, spreads, stock prices, Brazil

Abstract:

A large class of international business cycle models admits multiple locally isolated deterministic steady states, if the elasticity of substitution between traded goods is sufficiently low. I explore the conditions under which such multiplicity occurs and characterize the dynamic properties in the neighborhood of each steady state. Models with standard incomplete markets, portfolio costs, a debt-elastic interest rate, or an overlapping generations framework allow for multiple steady states, if the model features multiple steady states under financial autarchy. If the excess demand for the foreign traded good is increasing in the good's own price in a given steady state, the equilibrium dynamics around this steady state are unbounded. Otherwise, the dynamics are bounded and unique. By contrast, with Uzawa-type preferences, the steady state is always unique and the associated equilibrium dynamics are always bounded and unique. The same results obtain under complete markets.

Keywords: Stationarity, incomplete markets, open economy, multiple equilibria

Abstract:

This paper analyzes the quality of VAR-based procedures for estimating the response of the economy to a shock. We focus on two key issues. First, do VAR-based confidence intervals accurately reflect the actual degree of sampling uncertainty associated with impulse response functions? Second, what is the size of bias relative to confidence intervals, and how do coverage rates of confidence intervals compare with their nominal size? We address these questions using data generated from a series of estimated dynamic, stochastic general equilibrium models. We organize most of our analysis around a particular question that has attracted a great deal of attention in the literature: How do hours worked respond to an identified shock? In all of our examples, as long as the variance in hours worked due to a given shock is above the remarkably low number of 1 percent, structural VARs perform well. This finding is true regardless of whether identification is based on short-run or long-run restrictions. Confidence intervals are wider in the case of long-run restrictions. Even so, long-run identified VARs can be useful for discriminating among competing economic models.

Keywords: Vector autoregression, dynamic stochastic general equilibrium model, confidence intervals, impulse response functions, identification, long run restrictions, specification error, sampling

Abstract:

The Barro-Gordon inflation bias has provided the most influential argument for fixed exchange rate regimes. However, with low inflation rates now widespread, credibility concerns seem no longer relevant. Why give up independent monetary policy to contain an inflation bias that is already under control? We argue that credibility problems do not end with the inflation bias and they are a larger drawback for flexible exchange rates than usually thought. Absent commitment, independent monetary policy can induce expectation traps---that is, welfare ranked multiple equilibria---and perverse policy responses to real shocks, i.e., an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply that flexible exchange rates feature unnecessary macroeconomic volatility.

Keywords: Time inconsistency, independent monetary policy, exchange rate regimes

Abstract:

Over the past twenty years, U.S. import prices have become less responsive to the exchange rate. We propose that a significant portion of this decline is a result of increased trade integration. To illustrate this effect, we develop an open economy DGE model in which trade occurs along both the intensive and extensive margins. The key element we introduce into this environment is strategic complementarity in price setting. As a result, a firm's pricing decision depends on the prices set by its competitors. This feature implies that a foreign exporter finds it optimal to vary its markup in response to shocks that change the exchange rate, insulating import prices from exchange rate movements. With increased trade integration, exporters have become more responsive to the prices of their competitors and this change in pricing behavior accounts for a significant portion of the observed decline in the sensitivity of U.S import prices to the exchange rate.

Keywords: Pass-through, trade integration, strategic complementarity

Abstract:

This paper studies the transmission of volatility and trading activity in the foreign exchange market across trading regions for the euro-dollar and dollar-yen currency pairs, using high-frequency intraday data from Electronic Broking Services (EBS). In contrast with previous studies that use indicative quote frequency to proxy for trading activity, we use actual regional trading volume to identify five distinct trading regions in the foreign exchange market: Asia Pacific, the Asia-Europe overlap, Europe, the Europe-America overlap, and America. Based on realized volatility computed from high-frequency data and a regional volatility model, we find statistically significant evidence for volatility spillovers at both the own-region and the inter-region levels, but the economic significance of own-region spillovers is much more important than that of inter-region spillovers. We also examine the transmission of trading activity (trading volume and number of transactions) across the five trading regions and find similar results to those for volatility, but the economic significance of own-region spillovers is even more dominant.

Keywords: Exchange rate, volatility, trading volume, high-frequency data

Abstract:

We analyze the factors driving the widely-noted persistence in asset return volatility using a unique dataset on global euro-dollar exchange rate trading. We propose a new simple empirical specification of volatility, based on the Kyle-model, which links volatility to the information flow, measured as the order flow in the market, and the price sensitivity to that information. Through the use of high-frequency data, we are able to estimate the time-varying market sensitivity to information, and movements in volatility can therefore be directly related to movements in two observable variables, the order flow and the market sensitivity. The empirical results are very strong and show that the model is able to explain almost all of the long-run variation in volatility. Our results also show that the variation over time of the market's sensitivity to information plays at least as important a role in explaining the persistence of volatility as does the rate of information arrival itself. The econometric analysis is conducted using novel estimation techniques which explicitly take into account the persistent nature of the variables and allow us to properly test for long-run relationships in the data.

Keywords: Volatility persistence, news sensitivity, exchange rates, long memory, fractional cointegration, narrow band spectral regression

Abstract:

Though China's share of world trade is comparable to that of Japan, little is known about the response of China's trade to changes in exchange rates. The few estimates available suffer from two limitations. First, the data for trade prices are based on proxies for prices from other countries. Second, the estimation sample includes the period of China's transformation from a centrally-planned economy to a market-oriented system. To address these limitations, this paper develops an empirical model explaining the shares of China's exports and imports in world trade in terms of the real effective value of the renminbi. The specifications control for foreign direct investment and for the role of imports of parts to assemble merchandise exports. Parameter estimation uses disaggregated monthly trade data and excludes the period during which most of China's decentralization occurred. The estimation results suggest that a ten-percent real appreciation of the renminbi lowers the share of aggregate Chinese exports by a half of a percentage point. The same appreciation lowers the share of aggregate imports by about a tenth of a percentage point.

Keywords: Renminbi, foreign direct investment, income elasticitiy, trade shares, automated specification

Abstract:

We provide a tractable model to study monetary policy under discretion. We focus on Markov equilibria. For all parametrizations with an equilibrium inflation rate around 2%, there is a second equilibrium with an inflation rate just above 10%. Thus the model can simultaneously account for the low and high inflation episodes in the U.S. We carefully characterize the set of Markov equilibria along the parameter space and find our results to be robust.

Keywords: Time inconsistency, inflation, expectation traps

Abstract:

A striking feature of U.S. trade is that both imports and exports are heavily concentrated in capital goods and consumer durables. However, most open economy general equilibrium models ignore the marked divergence between the composition of trade flows and the sectoral composition of U.S. expenditure, and simply posit import and exports as depending on an aggregate measure of real activity (such as domestic absorption). In this paper, we use a SDGE model (SIGMA) to show that taking account of the expenditure composition of U.S. trade in an empirically-realistic way yields implications for the responses of trade to shocks that are markedly different from those of a "standard" framework that abstracts from such compositional differences. Overall, our analysis suggests that investment shocks, originating from either foreign or domestic sources, may serve as an important catalyst for trade adjustment, while implying a minimal depreciation of the real exchange rate.

Keywords: SDGE model, open-economy macroeconomics

Abstract:

Corporate governance can provide mechanisms to effectively monitor the use of derivatives. Using a sample of firms from 34 countries over the period 1990 to 1999, I find that firms with strong governance use currency derivatives for value-maximizing reasons as established by theory. On the other hand, firms with weak governance use such derivatives mostly for managerial self-interests and selective hedging. These results are robust to using a sample of US firms, the use of foreign denominated debt as an alternative strategy to hedge currency risk, selection bias, and a possible endogeneity between hedging policies, corporate governance, and other financial policies. Overall, the results serve as the first comprehensive evidence on the impact of corporate governance on why firms use derivatives and consequently why they hedge.

Keywords: Derivatives, corporate governance, hedging, international finance

Abstract:

This paper takes an in-depth look at U.S. direct investment valuation adjustments. We develop a methodology to generate valuation adjustments at the quarterly frequency, which can be combined with the Bureau of Economic Analysis's quarterly direct investment flows to obtain quarterly estimates of direct investment assets and liabilities. Our methodology involves two steps. First, we estimate valuation adjustment models with annual data. Our models rely on variables that reflect terms used by the Bureau of Economic Analysis in their data construction: exchange-rate changes, changes in the price of products, and changes in stock-market prices. Second, we apply quarterly data to the estimated models to generate quarter valuations and implement a procedure that ensures that the estimated valuations for the four quarters in a given year sum to the reported annual valuation adjustments. With this framework we consider how asset price shocks affect the net direct investment position and, hence, net international investment position.

Keywords: Net direct investment position, net international investment position, exchange rates, stock markets

Abstract:

We investigate the possibility that the large current account deficits of the U.S. are the outcome of optimizing behavior. We develop a simple long-run world equilibrium model in which the current account is determined by the expected discounted present value of its future share of world GDP relative to its current share of world GDP. The model suggests that under some reasonable assumptions about future U.S. GDP growth relative to the rest of the advanced countries -- more modest than the growth over the past 20 years -- the current account deficit is near optimal levels. We then explore the implications for the real exchange rate. Under some plausible assumptions, the model implies little change in the real exchange rate over the adjustment path, though the conclusion is sensitive to assumptions about tastes and technology. Then we turn to empirical evidence. A test of current account sustainability suggests that the U.S. is not keeping on a long-run sustainable path. A direct test of our model finds that the dynamics of the U.S. current account -- the increasing deficits over the past decade -- are difficult to explain under a particular statistical model (Markov-switching) of expectations of future U.S. growth. But, if we use survey data on forecasted GDP growth in the G7, our very simple model appears to explain the evolution of the U.S. current account remarkably well. We conclude that expectations of robust performance of the U.S. economy relative to the rest of the advanced countries is a contender -- though not the only legitimate contender -- for explaining the U.S. current account deficit.

Abstract:

Using Monte Carlo simulations, I show that typical out-of-sample forecast exercises for stock returns are unlikely to produce any evidence of predictability, even when there is in fact predictability and the correct model is estimated.

Keywords: Stock return predictability, Out-of-sample tests

Abstract:

I show that the test procedure derived by Campbell and Yogo (2005, Journal of Financial Economics, forthcoming) for regressions with nearly integrated variables can be interpreted as the natural t-test resulting from a fully modified estimation with near-unit-root regressors. This clearly establishes the methods of Campbell and Yogo as an extension of previous unit-root results.

Keywords: Fully modified estimation, Near-unit-roots, Predictive regressions

Abstract:

I develop new results for long-horizon predictive regressions with overlapping observations. I show that rather than using auto-correlation robust standard errors, the standard t-statistic can simply be divided by the square root of the forecasting horizon to correct for the effects of the overlap in the data; this is asymptotically an exact correction and not an approximate result. Further, when the regressors are persistent and endogenous, the long-run OLS estimator suffers from the same problems as does the short-run OLS estimator, and it is shown how similar corrections and test procedures as those proposed for the short-run case can also be implemented in the long-run. New results for the power properties of long-horizon tests are also developed. The theoretical results are illustrated with an application to long-run stock-return predictability, where it is shown that once correctly sized tests are used, the evidence of predictability is generally much stronger at short rather than long horizons.

Keywords: Predictive regressions, long-horizon regressions, stock return predictability

Abstract:

This paper considers the estimation of average autoregressive roots-near-unity in panels where the time-series have heterogenous local-to-unity parameters. The pooled estimator is shown to have a potentially severe bias and a robust median based procedure is proposed instead. This median estimator has a small asymptotic bias that can be eliminated almost completely by a bias correction procedure. The asymptotic normality of the estimator is proved. The methods proposed in the paper provide a useful way of summarizing the persistence in a panel data set, as well as a complement to more traditional panel unit root tests.

Keywords: Local-to-unity, panel data, pooled regression, median estimation, bias correction

Abstract:

This paper examines the current thinking on exchange-rate pass-through to both import prices and consumer prices and estimates the extent to which they have fallen in the G-7 countries since the late 1970s and 1980s. For import-price pass-through we find that all countries experience a numerical decline in the responsiveness of import prices to exchange-rate movements; for nearly half of these countries the decline between 1975-1989 and 1990-2004 is statistically significant. We estimate that while a 10 percent depreciation in the local currency would have increased import prices by nearly 7 percent on average across these countries in the late 1970s and 1980s, it would have only increased import prices by 4 percent in the last 15 years. The responsiveness of consumer prices to exchange-rate movements declines for nearly every country, with the decline being statistically significant for two countries. Specifically, while a 10 percent depreciation in the local currency would have increased consumer prices by almost 2 percent on average in the late 1970s and 1980s, it would have had a neutral effect on consumer prices in the last 15 years.

Keywords: Inflation, consumer prices, import prices, exchange rates, pass-through

Abstract:

This paper assesses whether partial exchange rate pass-through to trade prices has important implications for the prospective adjustment of global external imbalances. To address this question, we develop an open-economy DGE model in which firms set their prices with an eye toward maintaining their competitiveness against other producers; this feature of the model generates a variable desired markup and, hence, pass-through that is less than complete. With trade price elasticities of unity or greater, we find that for a given move in the exchange rate the nominal trade balance adjusts more when pass-through is high. However, an ofsetting consideration is that the exchange rate tends to be more sensitive to shocks in a low pass-through environment. We show that the relative importance of these considerations depends on the structural features of the economy, including the magnitude of the trade price elasticities and the sensitivity of private spending to shocks.

Keywords: Import prices, Export prices, Trade balance, Marshall-Lerner condition, DGE model