Contributions published at Financial Economics (Thorsten Hens)

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This paper introduces and analyzes an evolutionary model of a financial market with a risk-free asset. Focus is on the study of local stability of the wealth dynamics through the application of recent results on the linearization and stability of random dynamical systems (Evstigneev, Pirogov and Schenk-Hoppé, Proceedings of the American Mathematical Society 139, 1061-1072, 2011). Conditions are derived for the linearization of the model at an equilibrium state which ensure local convergence of sample paths to this equilibrium. The paper also shows that the concept of local stability is closely related to the notion of evolutionary stability. A locally evolutionarily stable investment strategy in the evolutionary model with a risk-free asset is derived, extending previous research. The method illustrated here is applicable for the analysis of manifold economic and financial dynamic models involving randomness.

In diesem Artikel werden die Grundzüge der Geldpolitik der Schweizerischen Nationalbank (SNB) und der Inflationsentwicklung seit ihrer Gründung 1907 dargestellt. Vereinfachend lassen sich drei geldpolitische Phasen unterscheiden, die der jeweils vorherrschenden internationalen Währungsordnung entsprechen. In der ersten Phase bestimmte der Goldstandard die Geldpolitik. Nach dem Zweiten Weltkrieg löste das Bretton-Woods-System den Goldstandard ab. In beiden Phasen waren die Wechselkurse fest. Die dritte Phase hat in der ersten Hälfte der 1970er-Jahre begonnen und ist durch flexible Wechselkurse charakterisiert.

In December 1999 the Swiss National Bank (SNB) abandoned monetary targeting and introduced a new monetary policy strategy. The cornerstones of the new framework are an explicit definition of what the SNB considers to be price stability, a forecast of inflation over a three-year horizon, and a target range for the three-month Swiss franc Libor. The strategy lived up to expectations in every respect and contributed to strengthening the SNB's credibility. In particular, the new framework's flexibility proved successful in times of financial stress. The term reference interest rate contains an automatic monetary stabilizer that has insulated the nonfinancial sector from much of the turbulence. The major challenge lying ahead is sustained accuracy in the assessment of future inflation.

We use intraday trading and order data to measure liquidity in the foreign exchange (FX) market. FX liquidity exhibits significant cross-sectional and temporal variation during our sample period January 2007--December 2009. We decompose liquidity into an idiosyncratic and a common component. Empirical results show that liquidity comoves strongly across currencies and that systematic FX liquidity decreases dramatically during the financial crisis. Consistent with a theory of liquidity spirals, we document that FX market liquidity is related to funding liquidity and liquidity of equity markets. Finally, we introduce a tradable FX liquidity risk factor, which is shown to account for most of the variation in daily carry trade returns.

Arbitrage normally ensures that covered interest parity (CIP) holds. Until recently, excess profits, if any, were documented to last merely seconds and reach a few pips. Instead, this paper finds that following the Lehman bankruptcy, these were large, persisted for months and involved strategies short in dollars. Profits are estimated by specifying the arbitrage strategy as a speculator would actually implement it, considering both unsecured and secured funding. Either way, it seems that dollar funding constraints kept traders from arbitraging away excess profits. The claim finds support in an empirical analysis drawing on several novel high frequency datasets of synchronous quotes across securities, including transaction costs.

In many countries, tax authorities treat building savings favorably, in order to incentivize homeownership. A solution that addresses home price risk can be provided by using property derivatives. Index-linked mortgages thus provide Pareto improvements by allocating collateral risk more optimally and by reducing the number of default and related costs. Housing is one of the biggest financial assets that most households will ever own. However, management of housing risk is difficult, since there are virtually no instruments that insure against rising or falling home prices. The financial solutions which are described in this chapter would be able to allocate risks and returns more appropriately. Linking the financial instruments that are commonly used in the context of housing, building savings, and mortgages, to a home price index addresses the issues naturally.

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This paper studies the Cass-Koopmans-Ramsey model of optimal economic growth in the presence of loss aversion and habit formation. The representative agent's preferences for consumption can be gradually varied between the standard constant intertemporal elasticity of substitution (CIES) case and Kahneman and Tversky's prospect utility. We nd that the transitional dynamics of optimal consumption paths differ distinctly from the standard model, in particular consumption smoothing is more pronounced. We also show that prospect utility can cause the economy to remain in a steady state with low consumption and low capital.

Framing effects are said to indicate irrationality in decision making because they illustrate that linguistically different descriptions of equivalent options lead to inconsistent choices. A review of the literature on the effects of adding, or subtracting, implicated complements of the sure option shows that this leads to a classic framing effect, a reversal of the classic effect, or no framing effect. Thus, the assumption of equivalence of formulations is not justified. In addition we provide a test of two major, but opposing theories on framing, prospect theory and fuzzy-trace theory. Based on an online study we investigated the effects of subtracting complements of the risky option. The results are more consistent with fuzzy-trace theory than with prospect theory. The consequences of these findings for the application of formal models like prospect theory, and for rationality, are discussed.

The pricing kernel puzzle is the observation that the pricing kernel might be increasing in some range of the market returns. This paper analyzes the pricing kernel in a financial market equilibrium. If markets are complete and investors are risk-averse and have common and true beliefs, the pricing kernel is a decreasing function of aggregate resources. If at least one of these assumptions is violated, the pricing kernel is not necessarily decreasing. Thus, incomplete markets, risk-seeking behaviour and incorrect beliefs can induce increasing parts in the pricing kernel and can be seen as potential solutions for the pricing kernel puzzle. We construct examples to illustrate the three explanations. We verify the robustness of the explanations under aggregation and compare the phenomena with the findings in the empirical literature. The results are used to reveal strengths and weaknesses of the three solutions. Risk-seeking behaviour is a fragile explanation that can only work in a model with atomic state space. Biased beliefs are robust under aggregation and consistent with the empirical findings. In incomplete markets, it is easy to find a pricing kernel with increasing parts. In order to get situations where all pricing kernels have increasing parts, we need extreme assumptions on the wealth distribution.

This paper presents a simple model of the firm life cycle that captures several stylized economic and financial features which usually require considerably more demanding approaches. We study the optimal capital accumulation policy of a financially constrained firm whose revenue is subject to an additive shock. Earnings can be paid as dividends or reinvested with the goal to maximize shareholder value. In our model, the optimal policy of firms is to reinvest earnings (rather than paying dividends) when small, hold precautionary savings, and grow larger than is socially optimal. Smaller firms also have a higher bankruptcy risk and a more volatile market value than larger firms. We observe the leverage effect and excess returns of value stocks. In the presence of business cycles, investment and initial public offerings are pro-cyclical, the default probability is counter-cyclical, and monetary policy increases excess capital holdings but otherwise has a negligible impact.

We consider a repeated stochastic coordination game with imperfect public monitoring. In the game any pattern of coordinated play is a perfect Bayesian Nash equilibrium. Moreover, standard equilibrium selection arguments either have no bite or they select an equilibrium that is not observed in actual plays of the game. We give experimental evidence for a unique equilibrium selection and explain this very robust finding by equilibrium selection based on behavioral arguments, in particular focal point analysis, probability matching and overconfidence. Our results have interesting applications in finance because the observed equilibrium exhibits momentum, reversal and excess volatility. Moreover, the results may help to explain why technical analysis is a commonly observed investment style.