Working Papers

Authors: Neil Shephard, Tina Hviid Rydberg

Jan 2002

In this paper we introduce a decomposition of the joint distribution of price changes of assets recorded trade-by-trade. Our decomposition means that we can model the dynamics of price changes using quite simple and interpretable models which are easily extended in a great number of directions, including using durations and volume as explanatory variables. Thus we provide an econometric basis for empirical work on market microstructure using time series of transactions data. We use maximum likelihood estimation and testing methods to assess the fit of the model to a year of IBM stock price data taken from the New York Stock Exchange.

Keywords: Activity, autologistic, conditional independence, decomposition, directions, durations, forecasting, GLARMA, logarithmic distribution, prediction decomposition, size, transactions data

Reference: 2002-FE-04

Authors: Walter  Eltis

Dec 2001

Authors: Linda Y. Yueh

Dec 2001

The move to a more market-oriented economy is associated with evidence of increased inequality in the incomes earned by men and women. The context of our study of this question is the recent large-scale reform of the inefficient state sector, which has caused layoffs of urban workers that dramatically changed the state of employment in urban China. One factor in determining success in an imperfect labour market could be related to guanxi, the Chinese variant of social capital. We develop a model of social capital in which the decision to invest in guanxi is a function of time and resources expended, which may reflect and cause gender differences. Our original measures of social capital are created with a data set administered in urban China in early 2000. We find that there are gender differences in the stock of social capital and returns within the labour market. Women have less social capital than men and also lower economic returns in terms of earned income.

JEL Codes: D0, J16, J22, J71, O53

Keywords: general microeconomics, gender, discrimination, social capital, China

Reference: 83

Individual View

Authors: Paul A. Davi, dDominique Foray, CNRS and Institut pour le Management de la Recherche et de l`Innovation, Paris-Dauphine University

Dec 2001

This introductory article reviews the main themes relating to the development of new knowledge-based economies. After placing their emergence in historical perspective and proposing a theoretical framework which distinguishes knowledge from information, the authors characterize the specific nature of such economies. They go on to deal with some of the major issues concerning the new skills and abilities required for integration into the knowledge-based economy; the new geography that is taking shape (where physical distance ceases to be such an influential constraint); the conditions governing access to both information and knowledge, not least for developing countries; the uneven development of scientific, technological (including organizational) knowledge across different sectors of activity; problems concerning intellectual property rights and the privatization of knowledge; and the issues of trust, memory and the fragmentation of knowledge.

JEL Codes: D80, O31, O34

Keywords: knowledge, information, codification, intellectual property

Reference: 84

Individual View

Authors: Vijay Joshi, Mary Sissons Joshi, Psychology Department, Oxford Brookes University Roger Lamb, Psychology Department, Oxford Brookes University

Dec 2001

It is commonly asserted that such problems as inner-city traffic congestion and pollution can be understood as examples of the Prisoner`s Dilemma Game (PD), but there is a dearth of empirical research that tests this assertion. 587 car owners in Oxford City were presented with three pairs of alternatives designed as traffic versions of the four outcomes of the PD, and asked to state which alternative in each pair they preferred. Only 2% of respondents showed the full set of preferences which fit the PD. Four sets of preferences accounted for 93% of responses suggesting that no single canonical game structure can represent the traffic problem. The most common set of preferences, shown by 48% of respondents fitted as `Assurance Game`. The results imply that the current traffic problem may be due to lack of assurance and trust rather than raw self-interest. The public policy implications of the data are discussed.

Reference: 85

Individual View

Three issues are addressed in this paper. First, we use both household and macro data to establish how fast per capita consumption and incomes grew in Ghana in the 1990s. Second, we ask how much of the rise in incomes was due to rises in the level of human capital and how much reflected underlying technical progress. Third, we assess the implications of how incomes rose for the interpretation of changes in the poverty profile. Four household surveys are used to show changes in both expenditures and incomes over the decade. The household surveys show that both consumption per capita and incomes rose by 12 per cent, a rate of 1 per cent per annum. This figure is identical to the growth rate for consumption per capita implied by the macro accounts. The average level of education of the population rose by 27 per cent over the decade which led to a rise of 3 per cent in per capita consumption. We find, on average, no evidence for any underlying technical progress. We show that the rise in income was associated with modest falls in the head count and poverty gap measures of poverty but with virtually no change in the severity of poverty measure. The fall in the head count measure was too small to prevent the absolute number of poor people from rising. Inequality increased with the incomes of the non-agricultural self-employed, with given levels of human capital, falling both absolutely and relative to wage workers.

JEL Codes: J30, O55

Keywords: Ghana, real incomes, poverty

Reference: WPS/2001-21

This paper examines the efficiency of stock based compensation by valuing stock and options from the executive`s point of view. Companies give compensation in the form of stock in order to align incentives by providing a link between executive wealth and the stock price performance of the company. However, it requires the executive to be exposed to firm-specific risk, and thus hold a less than fully diversified portfolio. Since firm-specific risk is not priced, this leads to the executive placing less value on the options than their cost to the company, given by their market value. We propose a continuous time, utility maximisation model to value the executive`s compensation. We endogenise allocation of the executive`s non-option wealth as the executive may invest in the market portfolio. Executives trade the market portfolio to adjust exposure to market risk, but are subject to firm-specific risk for incentive purposes. By distinguishing between these two types of risks, we are able to examine the effect of stock volatility, firm-specific risk, market risk and the correlation between the stock and the market, on the value to the executive and incentives. We can prove that there is a negative relationship between firm-specific risk and value, if volatility is fixed. However, the value may increase or decrease with firm-specific risk if market risk is fixed. The same ambiguous relationship is found if we consider value as a function of volatility, so executives will not always aim to increase the volatility of the stock price. Just as the value of the compensation to the executive is overstated in a Black Scholes model, the Black Scholes model also exaggerates the incentives for the executive to increase the stock price. We address the question of how the company can maximise incentives (for a given cost) and show that if stock compensation replaces cash remuneration, it is optimal to compensate with stock, rather than options.

JEL Codes: D52, G13, G30, G32, J33, M12

Keywords: executive stock options

Reference: 2002-FE-01

Authors: Nicholas Dimsdale, N. Horsewood, University of Birmingham

Oct 2001

This paper examines the factors contributing to the rise in unemployment in Australia during the depression of the 1930s and to its decline in the subsequent recovery. While previous writers have generally argued that demand side variables were predominant, it has also claimed that excessive real wages created unemployment. The Layard-Nickell model, which has been used to examine the relationship between real wages and unemployment in interwar Britain, is estimated from Australian data. The results of the estimation confirm that demand side variables in the form of changes in government spending and in the terms of trade were important in both the downturn and the recovery. Although real wages affected employment and wage indexation procedures resulted in some real wage rigidity this was not a major contributor to unemployment. In addition wage indexation resulted in a high degree of flexibility of money wages, so that nominal inertia was not a problem This is in contrast to a country, such as the UK, where wages are determined by collective bargaining rather than by formal wage regulation. No evidence was found that the much discussed decision of the Commonwealth Court to reduce real wages by 10% was effective.

JEL Codes: E24, N17, N37

Keywords: unemployment, Great Depression, wage indexation, Australia

Reference: 81

Individual View

Authors: Terry O'Shaughnessy

Oct 2001

This paper examines an open economy model in which equilibrium unemployment depends on capacity in the traded-goods sector. The model is estimated using U.K. quarterly data and compared with alternative concepts of equilibrium unemployment based on labour market variables (as in Layard and Nickell, 1986) or on the price of oil and the real interest rate (as in Carruth, Hooker and Oswald, 1998). The capacity model displays a non-linear hysteresis mechanism through which capacity utilisation and the degree of volatility of the real exchange rate interact to generate changes in equilibrium unemployment. This is modelled as logistic smooth transition autoregressive (LSTAR) process.

JEL Codes: E22, E24, F41

Keywords: unemployment, hysteresis, capacity, smooth transition, real exchange rate

Reference: 82

Authors: Michael Bacharach, Gerardo A. Guerra, Daniel John Zizzo

Oct 2001

A person is said to be `trust responsive` if she fulfils trust because she believes the truster trusts her. The experiment we report was designed to test for trust responsiveness and its robustness across payoff structures, and to disentangle it from other possible factors making for trustworthiness, including perceived kindness, perceived need, and inequality aversion. We elicit the truster`s confidence that the trustee will fulfil, and the trustee`s belief about the truster`s confidence after the trustee receives evidence relevant to this. We find evidence of strong trust responsiveness. We also find that perceptions of kindness and of need increase trust responsiveness, and that perceptions of kindness and need raise fulfilling rates only in conjunction with trust responsiveness.

JEL Codes: C79, C92, D84

Keywords: trust game, experiment, trust responsiveness, kindness, need to trust, belief elicitation

Reference: 76

Individual View

Authors: David Hendry, Michael P. Clements, Department of Economics, University of Warwick

Oct 2001

This paper describes some recent advances and contributions to our understanding of economic forecasting. The framework we develop helps explain the findings of forecasting competitions and the prevalence of forecast failure. It constitutes a general theoretical background against which recent results can be judged. We compare this framework to a previous formulation, which was silent on the very issues of most concern to the forecaster. We describe a number of aspects which it illuminates, and draw out the implications for model selection. Finally, we discuss the areas where research remains needed to clarify empirical findings which lack theoretical explanations.

JEL Codes: C1, C52

Keywords: forecasting, non-stationarity, structural breaks, co-breaking, pooling, model selection

Reference: 78

Authors: Emilia Del Bono

Oct 2001

The aim of this work is to explore the relationship between unemployment and fertility. The hypothesis we investigate is that unemployment affects fertility decisions by influencing individual`s expectations of future job opportunities and wage levels. A spell of unemployment may induce women to bring forward or delay the birth of their first child, depending on the relative strength of the income and substitution effects. Our results show that expectations of future wage levels and future job opportunities are relevant in explaining fertility patterns. In particular, higher expected wage levels encourage women to work more and delay childbirth. By contrast, more favourable expected job opportunities raise the hazard of a birth and, everything else equal, induce women to bring forward the event. In the latter case, a dominating income effect seems to be at work.

JEL Codes: J13, J60, C41

Keywords: fertility, unemployment duration analysis

Reference: 80

Individual View

Authors: Stefan Dercon

Oct 2001

In applied welfare economics, equivalence scales for household composition and size corrections, and appropriate price deflators are minimum requirements to perform interhousehold comparisons of welfare, measured via household income or consumption information. In practice, the information available is insufficient and only approximate price or household composition corrections are available. Poverty comparisons between groups or over time are then problematic. In this paper, Atkinson`s standard results on first order stochastic (welfare) dominance are extended to allow for pairwise comparisons of poverty of groups with different needs or facing different prices, when there is uncertainty on the true cost-of-living deflators and equivalence scales. The approach is illustrated using household surveys from Ethiopia and Burkina Faso.

Keywords: poverty orderings, welfare dominance, equivalence scales, price deflators.

Reference: 79

Individual View

Authors: Ariel Buira

Jul 2001

Since 1997, following the approval of the Guidance Note on Governance by the Executive Board, the IMF has given increased attention to governance issues in its member countries. In view of its influence, it is of interest to consider to what extent the Fund`s own governance meets the standards of transparency and accountability required for the good use of public resources. The paper reviews the power structure of the Fund, i.e. the distribution of quotas and the role of the Executive Board and of the staff and management in decision making. It finds that the concentration of power in a few countries impairs the transparency and political accountability of the Fund. It argues that as the changes in the world economy since the Bretton Woods Conference in 1944 have not been appropriately reflected in the quota structure some aspects of the system have become dysfunctional.

JEL Codes: F020, F330

Keywords: International Monetary Fund, international monetary system, governance of the IMF, decision making in the IMF, political control of the IMF, IMF quotas and voting power

Reference: 73

Individual View

Authors: Charles H. Feinstein, Mark Thomas

Jul 2001

This paper argues that all historical data series should be accompanied by formal estimates of their margins of error. We discuss the nature of errors in data series and review earlier attempts to assess their reliability. We show how overall margins of error may be calculated for historical series from judgments on the reliability of their components, and how these allow readers both to appraise the estimate and to test the implications of applying different standards. An illustration is provided for Hoffmanns index of British industrial output, 1770–1831. The calculations emphasize the value of this approach to the recent debate on growth rates during the industrial revolution and suggest its merits more generally.

Reference: 041

Individual View

Authors: Ariel Buira

Jul 2001

At the request of the Managing Director of the IMF, a group of experts, chaired by Professor Richard Cooper of Harvard University prepared a report on the adequacy of quota formulas, including proposals for changes. The paper reviews the recommendations of the Quota Formula Review Group and finds that the Report failed to address such key issues as the size of the Fund or overall adequacy of quotas, and the question of basic votes and the distribution of voting power. It questions the reasons for the rejection of PPP-based GDP in the proposed formula for quota determination and considers that this introduces a bias against developing countries; the exclusion of short-term capital movements in the measurement of countries external vulnerability also appears questionable

JEL Codes: F020, F330

Keywords: International Monetary Fund, international monetary system, governance of the IMF, decision making in the IMF, political control of the IMF, IMF quotas and voting power

Reference: 74

Individual View

Authors: Issam Hallak

Jul 2001

The paper explores the determinants of up-front fees on sovereign bank loans. Remuneration of bank loans is typically channelled through the floating interest benchmark, the interest spread, and a battery of fees. There is substantial evidence of the spread paying for long-run sovereign repayment capacity. Little is known, however, about the role of the fees paid up-front. Based on a uniquely extensive sample of LDCs sovereign loan contracts, this study provides substantial evidence of up-front fees capturing the costs due to the expected renegotiations and agency issues. This contradicts previous studies based on spreads only, predicting a pricing difference between public and private debt to LDCs sovereigns.

JEL Codes: F34, G21

Keywords: sovereign debt, syndicated loans, up-front fees, pricing design, less-developed countries

Reference: 75

Individual View

Authors: Alexander Guembel, Oren Sussman

Jul 2001

We analyze exchange-rate management by the central bank when it makes the FX market for the sake of social-welfare objectives. It is assumed that markets are incomplete, so that agents are exposed to exchange-rate volatility against which they cannot fully hedge. It follows that the central bank may provide insurance by smoothing the exchange rate. However, smoothing the exchange rate also creates arbitrage opportunities for spec-ulators. We show that the central bank cannot smooth the exchange rate and deter speculation at the same time. A Tobin tax may provide a way out.

Reference: 2001-FE-13

Authors: Neil Shephard, Ole E. Barndorff-Nielsen, University of Aarhus

Jul 2001

The availability of intra-day data on the prices of speculative assets means that we can use quadratic variation like measures of activity in financial markets, called realised volatility, to study the stochastic properties of returns. Here we derive the moments and the asymptotic distribution of the realised volatility error - the difference between realised volatility and the actual volatility. These properties can be used to allow us to estimate the parameters of stochastic volatility models.

JEL Codes: C32, G12

Keywords: econometrics, higher order variation, Kalman filter, leverage, lévy process, OU process, quarticity, quadratic variation, realised volatility, square root process, stochastic volatility, subordination, superposition.

Reference: 71

Authors: Paul David

Jul 2001

This essay examines the economics of patronage and the roles of asymmetric information and reputation in the early modern reorganization of scientific activities, specifically their influence upon the historical formation of key elements in the ethos and organizational structure of publicly funded open science. The emergence during the late 16th and early 17th centuries of the idea and practice of ‘open science’ represented a break from the previously dominant ethos of secrecy in the pursuit of ‘Nature’s Secrets.’ It was a distinctive and vital organizational aspect of the Scientific Revolution, from which crystallized a new set of norms, incentives, and organizational structures that reinforced scientific researchers’ commitments to rapid disclosure of new knowledge. The rise of ‘cooperative rivalries’ in the revelation of new knowledge, is seen as a functional response to heightened asymmetric information problems posed for the Renaissance system of court-patronage of the arts and sciences; pre-existing informational asymmetries had been exacerbated by increased importance of mathematics and the greater reliance upon sophisticated mathematical techniques in a variety of practical contexts of application. Analysis of the court patronage system of late Renaissance Europe, within which the new natural philosophers found their support, points to the significance of the feudal legacy of fragmented political authority in creating conditions of ‘common agency contracting in substitutes.’ These conditions are shown to have been conducive to more favorable contract terms (especially with regard to autonomy and financial support) for the agent-client members of western Europe’s nascent scientific communities.

Reference: 023

Individual View

Authors: Neil Shephard, Ole E. Barndorff-Nielsen, University of Aarhus

Jul 2001

This paper discusses two classes of distributions, and stochastic processes derived from them: modified stable (MS) laws and normal modified stable (NMS) laws. This extends corresponding results for the generalised inverse Gaussian (GIG) and generalised hyperbolic (GH) or normal generalised inverse Gaussian (NGIG) laws. The wider framework thus established provides, in particular, for added flexibility in the modelling of the dynamics of financial time series, of importance especially as regards OU based stochastic volatility models for equities. In the special case of the tempered stable OU process an exact option pricing formula can be found, extending previous results based on the inverse Gaussian and gamma distributions.

JEL Codes: C32, G12

Keywords: lévy process, inverse Gaussian, OU process, stable, stochastic volatility, subordination, tempered stable

Reference: 72

Using a newly constructed data set, we compare sources of funds and investment strategies of venture capital (VC) funds in Germany, Israel, Japan and the UK. Sources of VC funds differ significantly across countries, e.g. banks are particularly important in Germany, corporations in Israel, insurance companies in Japan, and pension funds in the UK. VC investment patterns also differ across countries in terms of the stage and sector of financed companies, as well as in the geographical focus of investments, and these differences are significantly related to the variations in funding sources. However, the influence of particular classes of institutions differs across countries. For example, bank backed VC firms in Germany and Japan are as involved in early stage finance as other funds in these countries, whereas in Israel and the UK they tend to invest in relatively late stage finance. While these financial institutional factors account for some of the differences in investment patterns across countries, other considerations (such as supply of entrepreneurs) are of greater significance.

JEL Codes: G20, O32

Keywords: Venture capital, financial institutions, sources of funds

Reference: 2001-FE-15

A recent report by Paul Myners for the UK Treasury has provided a wealth of information on the structure and operation of the pension fund industry in the UK. The report points to serious deficiencies in the governance of pension funds. These concerns are of considerable significance in their own right. But a fundamental focus of the Review is on their impact on the provision of private equity in the UK. This paper summarizes evidence from the Review and evaluates its proposed remedies. It concludes that to the extent that there is a private equity failure in the UK, it has less to do with the governance of institutions than with diversity and innovation in institutional design. The paper argues that financial regulation bears critically on the extent of institutional innovation and that US regulation has allowed its financial sector to respond more readily to the needs of high technology sectors than the UK`s.

Reference: 2001-FE-10

The credit derivatives market provides a liquid but opaque forum for secondary market trading of banking assets. I show that when entrepreneurs rely upon the certification value of bank debts to obtain cheap bond market insurance, the existance of a credit derivatives market may cause them to issue sub-investment grade bonds instead, and to engage in second-best behaviour. Credit derivatives can therefore cause disintermediation and thus reduce welfare. I argue that this effect can be most effectively countered by the introduction of reporting requirements for credit derivatives.

JEL Codes: G24, G28, G34

Keywords: Credit derivative, monitoring, junk bonds, debt finance, capital structure

Reference: 2001-FE-01

Authors: Colin Mayer, Julian Franks, Luc Renneboog

Apr 2001

Economic theory points to five parties disciplining management of poorly performing firms: holders of large share blocks, acquirers of new blocks, bidders in takeovers, non-executive directors, and investors during periods of financial distress. This paper reports the first comparative evaluation of the role of these different parties in disciplining management. We find that, in the UK, most parties, including holders of substantial share blocks, exert little disciplining and that some, for example, inside holders of share blocks and boards dominated by non-executive directors, actually impede it. Bidders replace a high proportion of management of companies acquired in takeovers but do not target poorly performing management. In contrast, during periods of financial constraints prompting distressed rights issues and capital restructuring, investors focus control on poorly performing companies. These results stand in contrast to the US, where there is little evidence of a role for new equity issues but non-executive directors and acquirers of share blocks perform a disciplinary function. The different governance outcomes are attributed to differences in minority investor protection in two countries with supposedly similar common law systems.

JEL Codes: G3

Keywords: Corporate governance, control, restructuring, board turnover, regulation

Reference: 1999-FE-01

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