CFAP Working Papers


Recent Submissions

Now showing 1 - 20 of 39
  • ItemOpen Access
    Cojumping: Evidence from the US Treasury Bond and Futures Market
    (2011-02) Dungey, Mardi; Hvozdyk, Lyudmyla
    The basis between spot and future prices will be affected by jump behavior in each asset price, challenging intraday hedging strategies. Using a formal cojumping test this paper considers the cojumping behaviour of spot and futures prices in high frequency US Treasury data. Cojumping occurs most frequently at shorter maturities and higher samling frequencies. We find that the presence of an anticipated macroeconomic news announcement is sufficient to change the probability of observing cojumps. Moreover, news surprises in non-farm payrolls, CPI, GDP and retail sales play a leading role in changing the probabilities of cojumps. However, surprises in non-farm payrolls also increase the probability of the cojumping tests being unable to determine whether jumps in spots and futures occur contemporaneously. On these occasions the market does not clearly signal its short term pricing behavior.
  • ItemOpen Access
    The Term Premium and The UK Economy 1980-2007
    (2010) Dungey, Mardi; Vehbi, M Tugrul
    The term premium is estimated from an empirically coherent open economy VAR model of the UK economy where the model specifically accounts for the mixed nature of the data and cointegration between some variables. Using this framework the estimated negative term premia for 1980-2007 is decomposed into its contributing shocks, where the role of inflation and monetary policy shocks are shown to be dominant in the evolution of the term premium. Projecting into the 2007-2008 crisis period reveals the extent of the shocks to the UK economy, and also shows the similarities in term premia behaviour with those experienced during the 1998 Russian crisis, likely reflecting the flight to cash experienced in both crises.
  • ItemOpen Access
    An empirical analysis of subprime consumer credit demand
    (2010) Alan, Sule; Lóránth, Gyöngyi
    We test the interest rate sensitivity of subprime credit card borrowers using a unique panel data set from a UK credit card company. What is novel about our contribution is that we were given details of a randomized interest rate experiment conducted by the lender between October 2006 and January 2007. We find that individuals who tend to utilize their credit limits fully do not reduce their demand for credit when subject to increases in interest rates as high as 3 percentage points. This finding is naturally interpreted as evidence of binding liquidity contraints. We also demonstrate the importance of truly exogenous variation in interest rates when estimating credit demand elasticities. We show that estimating a standard credit demand equation with nonexperimental variation leads to seriously biased estimates even when conditioning on a rich set of controls and individual fixed effects. In particular, this procedure results in a large and statistically significant 3-month elasticity of credit card debt with respect to interest rates even though the experimental estimate of the same elasticity is neither economically nor statistically different from zero.
  • ItemOpen Access
    On strategic default and liquidity risk
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2002) Tambakis, Demosthenes N
    How does the uncertain provision of external finance affect investment projects' default probability and liquidity risk? In this paper, I study the strategic interaction between many creditors and a single borrower in the context of a two-period investment project requiring external credit. Loans mature in one period but the project requires two periods to complete. The key working assumptions are that creditors are risk-averse and that any uncertainty is common knowledge: information about the fundamentals can be incomplete but not asymmetric. Mixed and perfect Bayesian strategies are used to compute the equilibrium probabilities of default and early liquidation. The impact of the maturity structure on default and liquidity risk is a function of the underlying structural and stochastic parameters and investors' beliefs about the state of fundamentals. The implications for banking regulation are assessed under fixed and variable loan rates. An open range of fundamentals is derived outside of which default and liquidity risk are either zero or one. The cyclical properties of default and liquidity risk are shown to depend sensitively on the relative cost of early liquidation to the borrower and the creditors, hence also on the regulatory policy stance.
  • ItemOpen Access
    The supervisory approach: a critique
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2002) Ward, Jonathan
    Rules suffer from two serious defects. The world is complex, and so the creation and application of rules is difficult; and it changes, so that rules become obsolete. In recent years, the conventional wisdom on financial regulation has shifted away from reliance on rules and back towards a ‘supervisory approach’, in which regulators rely more on banks’ own estimates of risk, and focus more on banks’ risk management systems and controls than on their compliance with crude rules. The Basel Committee’s proposals for a new Capital Accord (‘Basel 2’) follow this approach. In this paper I identify four problems with this approach. First, relying on banks’ estimates is not a solution to the problems caused by externalities. Secondly, for supervision to be effective, supervisors must have the skills, incentives and legal powers to change banks’ behaviour. It is difficult and costly to design a regime in which supervisors have desirable incentives. The supervisory approach appears ill-suited to the circumstances of developing countries, at least. Thirdly, the supervisory approach is based on qualitative standards and general principles. This delegates a great deal of discretion to bureaucrats, which is legally and politically difficult in many countries. Fourthly, the implementation of standards is essentially unobservable. As a result, the international regime will shift significantly towards decentralisation. An alternative approach would be to retain an emphasis on quantitative rules, and to improve the process for interpreting, enforcing and revising them.
  • ItemOpen Access
    Depreciation bias, financial-sector fragility and currency risk
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2002) Tambakis, Demosthenes N
    Do expected future exchange rate fluctuations affect current social welfare? In the third-generation approach to currency crises, financial fragility can trigger devaluation and default. Expected future depreciation is costly if it raises ex ante real interest rates. Given the strong violation of uncovered interest parity, expected future outcomes' current cost/benefit depends on the currency risk premium. I extend the static one-period Barro-Gordon welfare loss function to include expected future depreciation and show that, when foreign investors are risk-averse, depreciation bias is higher than the static case if aggregate demand is a function of ex ante real rates. If demand depends on the ex post real interest rate, average depreciation can be zero if current welfare is sufficiently sensitive to the state of the financial sector. In this stylised framework, depreciation bias can be mitigated even in the presence of time-inconsistency, and expected welfare may be higher.
  • ItemOpen Access
    The new Basel accord and developing countries: problems and alternatives
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2002) Ward, Jonathan
    The new Basel Accord framework relies on markets and supervisors to discipline banks. Yet both markets and supervisors fail, and more so in developing countries than in high-income countries. Therefore, the new Accord is not, as its designers claim, suitable for wide application. Nevertheless, developing country policymakers have little choice but to implement it in part or in whole. Hence there are problems of governance in international regulation. I offer seven general principles for the design of a prudential regime more robust to government and market failure. Four alternative capital regimes are evaluated in the light of these principles. Simpler and harsher regimes are likely to achieve greater safety with a given level of resources.
  • ItemOpen Access
    The World Trade Organization and financial stability: the balance between liberalisation and regulation in the GATs
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2003) Alexander, Kern
    The WTO General Agreement on Trade in Services and its Annex on Financial Services provide the international legal framework for the regulation of cross-border trade in financial services. This paper analyses some of the main provisions of the GATS and the Annex on Financial Services to determine its impact on domestic financial regulation and whether the GATS framework can achieve its objectives of liberalising international trade in financial services while allowing states to maintain adequate domestic regulatory institutions. The paper argues that the GATS provides a flexible framework for states to negotiate liberalisation commitments while allowing sufficient domestic regulatory authority to achieve financial stability objectives. The extent to which states can depart from their GATS obligations to achieve regulatory objectives has become the source of academic debate and policy interest. Although the WTO has played little or no role in the financial regulation debate, the GATS contains certain disciplines that could potentially have significant implications for limiting regulatory discretion over financial markets. The paper suggests that the Doha Development Agenda should address some of these issues as they relate to the regulation of cross-border trade in financial services. The role of the WTO in this area raises important issues regarding the institutional design of financial regulation and related issues of global financial governance.
  • ItemOpen Access
    Economic slowdown in the US, rehabilitation of fiscal policy and the case for a co-ordinated global reflation
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2003) Izurieta, Alex
  • ItemOpen Access
    Establishing a European securities regulator: is the European Union an optimal economic area for a single securities regulator?
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2002) Alexander, Kern
    The paper’s purpose is to address the economic, institutional, and legal issues confronting the establishment of a more centralised approach to EU securities regulation and to suggest that the theory of optimum currency areas can be used as a model to assess the economic benefits and costs of further centralisation of securities regulation in the European Union. The European Union’s Financial Services Action Plan seeks to achieve an integrated market in financial services in order to accomplish the economic and political objectives of the Treaty of Rome. The FSAP is premised on the notion that the adoption of legal and regulatory measures to achieve liberalisation in cross-border trade in financial services will also achieve integration of EU financial markets. This paper argues that liberalisation of financial markets does not necessarily lead to integration of financial markets. Furthermore, it argues that the institutional design and scope of financial regulation should be based, in part, on the extent of integration in the financial market. That is, the domain of the regulator should be the same as the domain of the market. European capital and financial markets remain fragmented and segmented. This paper argues therefore that, until EU financial markets become more integrated, a single EU securities regulator would not be an efficient or effective institutional model for EU securities markets. In other words, at present, the EU is not an optimal economic area for a single securities regulator.
  • ItemOpen Access
    Empirical modelling of contagion: a review of methodologies
    (Informa UK Limited, 2005-02) Dungey, M; Fry, R; Gonzalez Hermosillo, B; Martin, VL
    The existing literature promotes a number of alternative methods to test for the presence of contagion during financial market crises. This paper reviews those methods and shows how they are related in a unified framework. A number of extensions are also suggested which allow for multivariate testing, endogenous issues and structural breaks.
  • ItemOpen Access
    International financial contagion: what do we know?
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2003-07) Dungey, Mardi; Tambakis, Demosthenes N
    This paper attempts a synthesis of theoretical and empirical work on international financial contagion. Although a professional consensus on the appropriate definitions of contagion has yet to emerge, we document substantial research progress towards this goal. On the empirical front, determining when returns are ‘excessive’ is a pre-condition for designing effective policy response to crises. At the theoretical level, tracing the observed herding behavior to market participants’ uncertain beliefs and information asymmetries is a key element for understanding how contagious effects arise. It is argued that the recent focus on better understanding of high-frequency financial returns data and decision making at the market microstructure level are promising avenues for understanding the transmission of shocks across markets and countries.
  • ItemOpen Access
    Two-country stock-flow-consistent macroeconomics using a closed model within a dollar exchange regime
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2003) Godley, Wynne; Lavoie, Marc
  • ItemOpen Access
    Testing for changing persistence in US Treasury on/off spreads under weighted-symmetric estimation
    (Informa UK Limited, 2008-01) Smith, LV; Tambakis, DN
    We extend the recursive break test procedure of Leybourn et al. by using weighted-symmetric estimation to detect a single change in time series persistence. An application to U.S. Treasury bond on/off spreads finds a significant change in persistence from I(0) to I(1) in the late 1990s.
  • ItemOpen Access
    Features of a realistic banking system within a post-Keynesian stock-flow consistent model
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2004) Godley, Wynne; Lavoie, Marc
  • ItemOpen Access
    Regulating financial conglomerates
    (Elsevier BV, 2007-10) Freixas, X; Loranth, G; Morrison, AD
    We investigate the optimal regulation of financial conglomerates which combine a bank and a non-bank financial institution. The conglomerate’s risk-taking incentives depend upon the level of market discipline it faces, which in turn is determined by the conglomerate’s liability structure. We examine optimal capital requirements for stand-alone institutions, for integrated financial conglomerates, and for financial conglomerates that are structured as holding companies. For a given risk profile, integrated conglomerates have a lower probability of failure than either their stand-alone or decentralized equivalent. However, when risk profiles are endogenously selected, conglomeration may extend the reach of the deposit insurance safety net and hence provide incentives for increased risk-taking. As a result, integrated conglomerates may optimally attract higher capital requirements. In contrast, decentralised conglomerates are able to hold assets in the socially most efficient place. Their optimal capital requirements encourage this. Hence, the practice of “regulatory arbitrage”, or of transferring assets from one balance sheet to another, is welfare-increasing. We discuss the policy implications of our finding in the context not only of the present debate on the regulation of financial conglomerates but also in the light of existing US bank holding company regulation.
  • ItemOpen Access
    Aggregate liquidity shortages, idiosyncracic liquidity smoothing and banking regulation
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2005) Wagner, Wolf
    This paper develops a model of banking fragility driven by aggregate liquidity shortages. Inefficiencies arise because liquidity smoothing across banks breaks down when there is such a shortage, causing unnecessary and value-reducing transfer of assets between banks. We find that a Lender of Last Resort policy is ineffective in restoring efficiency as it leads to offsetting changes in the banks’ supply of liquidity. In contrast, subsidizing the purchase of assets from troubled banks increases welfare by improving the banks’ liquidity holdings. The first best, however, is achieved by redistributing liquidity from healthy to troubled banks in a crisis.
  • ItemOpen Access
    Credit risk transfer and financial sector performance
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2004) Wagner, Wolf; Marsh, Ian
    In this paper we study the impact of credit risk transfer (CRT) on the stability and the efficiency of a financial system in a model with endogenous intermediation and production. Our analysis suggests that with respect to CRT, the individual incentives of the agents in the economy are generally aligned with social incentives. Hence, CRT does not pose a systematic challenge to the functioning of the financial system and is generally welfare enhancing. However, we identify issues that should be addressed by the regulatory authorities in order to minimize the potential costs of CRT. These include: ensuring the development of new methods of CRT that allow risk to be more perfectly transferred, setting regulatory standards that reflect differences in the social cost of instability in the banking and insurance sector; promoting CRT instruments that are nor detrimental to the monitoring incentives of banks.
  • ItemOpen Access
    Finance and technical change: a neo-Schumpeterian perspective
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2004) Perez, Carlota
  • ItemOpen Access
    Simple open economy macro with comprehensive accounting a radical alternative to the Mundell Fleming model
    (CFAP, Cambridge Judge Business School, University of Cambridge, 2004-04) Godley, Wynne; Lavoie, Marc
    This paper presents a stock flow model of two economies (together comprising the whole world) which trade goods and financial assets with one another. The accounting framework, though comprehensive in its own terms, is very much simplified (it has interest rates without interest payments and exchange rate changes without changes in relative prices) so as to reach the main conclusions as simply and easily as possible. The paper is (a contrario) critical of attempts to deploy open economy models which only analyse the operations of a single economy, without regard to the responses of the rest of the world. In particular, the paper is critical of the influential Mundell-Fleming (M-F) model and finds that the characteristic M-F results are confuted once a full set of double entry accounts is used with all processes firmly located in historical time.