- “The Natural Level of Volatility”
Declining uncertainty induces leverage-driven expansions, diversification of idiosyncratic risks, and further compression of uncertainty. Natural volatility is the fixed point to this self-reinforcing process arising in a full information economy. It is pinned down by financial intermediaries’ equity and risk-bearing capacity, the technology linking leverage to project expansion, and the distribution of idiosyncratic shocks. There may be multiple natural volatility levels. Due to project deterioration in good times, the economy may become absorbed into self-reinforcing high-volatility regimes in which intermediaries’ risk assessments induce deleveraging and economic contractions, while contractions, by limiting diversification, in turn sustain high volatility. Consistent with the model predictions, cross-country estimates and evidence from staggered financial reforms support a volatility-compressing role for financialization. Periods of financial expansion in which volatility falls below its natural level predict financial crises over and above credit growth.
Preliminary draft: available upon requestDownload Download presentation
Interactive computational codes are available upon request
- “Natural Volatility, Complacency, and Near-Miss Crises”
Conventional crisis chronologies omit near-misses: episodes of financial distress that did not develop into systemic crises. We identify these episodes through a structural model of natural volatility, the level of volatility arising from the leverage-volatility cycle under accurate perceptions of risk, estimated independently of historical crisis dates. The model implies a natural probability of crisis, reflecting the irreducible systemic risk of financialization, and an effective probability that exceeds this benchmark when, during financial expansions, intermediaries underestimate volatility relative to its natural level. The resulting complacency wedge provides a structural measure of Hyman Minsky’s proposition that prolonged financial stability can induce the accumulation of systemic risk. We find that 21 of 23 independently documented U.S. near-misses occur during periods of complacency, with similar evidence from a twelve-country panel. We then use near-misses as counterfactuals to isolate the economic cost of systemic crises from that of the underlying financial disturbances. Across thirteen countries, crises entail additional output losses of approximately 5 percent after two years and 9 percent after ten.
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- “Asset Prices in an Endogenously Financialized Economy”
We investigate equity prices in the natural-volatility economy, where financial intermediation determines the creation and financing of firms. Firm value reflects both the payoff of a newly originated project and its stochastic continuation value, which depends on future credit conditions. The natural-volatility equilibrium has a corresponding natural valuation of equity. When intermediaries persistently estimate volatility to be below its natural level, the resulting leverage expansion and firm creation further lowers volatility through diversification, reinforcing the financial expansion and raising aggregate market capitalization above its natural level. These innovation waves generate asymmetric departures from natural valuations, driven primarily by firm creation rather than increases in individual firm values. Market valuations rise during financial expansions, peak around systemic crises, and decline thereafter.
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- “Learning Traps and Sovereign Debt”
Financial markets value sovereign debt by anticipating policy choices, but governments formulate their policy plans by learning from noisy information available through market prices. This feedback loop may generate learning traps, whereby favorable market conditions cause more sovereign debt accumulation than governments would have allowed under a rule-based commitment. This novel, information-based, time-inconsistency problem explains fiscal complacency, by which prolonged periods of benign market conditions predict subsequent debt accumulation and fiscal distress.
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- “Dipping in the Water: Fiscal Uncertainty and Public Debt Experimentation”
Governments may disagree with investors about the extent to which public expenditures offset the fiscal burden of debt. We develop a model in which governments face Knightian uncertainty about these fiscal offsets and learn from financial markets by announcing provisional spending plans before issuing debt. Such experimentation can be optimal even when deviations from announced plans are costly. While market responses reveal the fiscal offsets, the costs of revising initial promises make governments’ attitudes toward uncertainty consequential for their borrowing decisions. Prudent governments borrow less and tend to overestimate future debt-service costs. Optimistic governments borrow more, face greater default risk, and pay sovereign spreads that rise disproportionately with their optimism. We examine official European budget forecasts of economic growth and debt-service costs, documenting systematic differences that help distinguish prudent from optimistic governments.
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- “Fiscal Tipping Points and Sovereign Debt Cycles”
Governments accumulate debt when the marginal costs of borrowing are low. However, after prolonged debt accumulation, default probabilities rise rapidly, increasing the marginal costs of further debt issuance. Eventually, debt hits a critical threshold relative to the size of the economy, a fiscal tipping point, after which debt accumulation stalls, and governments cycle between deficits and surpluses, until perhaps a time of default. The main implications of this model are that (i) tipping points typically occur when distance-to-default is 10-20%; (ii) stable macroeconomic conditions delay tipping points, giving rise to two volatility paradoxes: default premiums are higher in countries that implement austerity earlier and remain positive even when exogenous risk is very small, (iii) liquidity and fiscal reforms have ambiguous effects on default risk; and (iv) austerity may arrive too late, leading to debt intolerance near the tipping point.
(Substantial revision of) CEPR Discussion Paper No. 16329Download Download presentation
- BOOK: Financial Stability: History, Crises, and Responses
Financial crises exert deep and persistent effects on economic activity and the allocation of capital. Yet the vulnerabilities that precede them often become apparent only when financial distress materializes. This book provides a systematic analysis of these episodes, emphasizing the interactions among credit expansion, leverage, expectations, institutional arrangements, and policy interventions. The book adopts three complementary perspectives. Part I explores major periods in financial history, including the Great Depression, the collapses of the Bretton Woods system, emerging-market crises, the Global Financial Crisis, and the European Debt Crisis. Part II examines several economic mechanisms at work in episodes of financial fragility, including bank runs, contagion, fire sales, endogenous risk, procyclical regulation, currency and sovereign debt crises, and asset price bubbles. Part III turns to the measurement and supervision of systemic risk, introducing quantitative tools such as Value at Risk, CoVaR, marginal expected shortfall, measures of financial interconnectedness, and indicators of sovereign default risk. By integrating historical evidence, economic theory, and quantitative risk measurement, the book provides a unified framework for understanding financial crises and evaluating policies aimed at preserving financial stability (approx. 350 pages).
- BOOK: Economia e Ideologia nel XXI Secolo (in Italian)
Deals with linkages between economic paradigms and ideologies through historical lenses mostly since WWI (approx. 250 pages).
- “Insider Trading Regulation and Market Quality Tradeoffs”
with Francesco Sangiorgi (Frankfurt School of Finance & Management)
Insider trading discourages outside investors’ information acquisition. Does this property imply that insider trading should be banned for the purposes of better market efficiency and liquidity? This paper provides a systematic analysis of three regulatory regimes with (i) insider trading bans, (ii) post-trade transparency, and (iii) unrestricted insider activities. When the cost to collect and process information is small and uncertainty is high, information crowding-out is so severe that bans are beneficial to market efficiency. Otherwise, information crowding-out is limited and post-trade transparency delivers the most efficient market. Markets are always the most liquid with a complete insider trading ban.
CEPR Discussion Paper No. 16179Download Download presentation
- “The Term Structure of Government Debt Uncertainty”
with Yoshiki Obayashi (Applied Academics LLC) and Shihao Yang (Georgia Institute of Technology, Harvard Medical School and Applied Academics LLC)
How valuable would it be to mitigate government debt volatility? This paper introduces a model that accounts for the complex structure of expected volatility in government bond markets and provides predictions regarding the fair value of derivatives referenced to this expected volatility. The model predicts that, unlike equity markets, futures markets on government bond volatilities frequently oscillate between episodes of backwardation and contango. This property helps explain events such as the reaction of the U.S. Treasury volatility curve to shocks including unanticipated Fed decisions or global economic imbalances. The paper provides quasi-closed form solutions that can readily be implemented despite the high-dimensional no-arbitrage restrictions that underlie the model dynamics.
CEPR Discussion Paper No. 13874Download Download presentation
- “Credit Volatility Indexes”
with Yoshiki Obayashi (Applied Academics LLC)
This paper contains details for implementing credit spread variance pricing methodologies based on credit default swap (CDS) options. A model independent formula for expected volatility is available, based on the prices of vanilla CDS options (VCOs). However, VCOs are currently not traded, and their prices must be inferred from those of actively traded CDS options with exotic payoffs (ECOs). Plugging ECO prices directly into the index formula is not theoretically justified, and the economic significance in the context of variance pricing of the difference in options contract specifications must be examined empirically. The paper develops methodology for converting observed ECO prices into hypothetical VCO prices for the purpose of index calculation, and assesses the economic impact of using ECOs and VCOs on index values under realistic market conditions.
Swiss Finance Institute Research Paper Series No. 20-88Download
This paper supersedes our SFI Research Paper No. 13-24: Mele, A. and Y. Obayashi (2013): “Credit Variance Swaps and Volatility Indexes.”
- “Volatility Begets Ambiguity: Volatility-Uncertainty Spirals in Asset Markets”
with Francesco Sangiorgi (Frankfurt School of Finance & Management)
We consider a market for a long-term security traded throughout overlapping generations. Agents are unsure about whether the future realization of the asset payoff is subject to sudden bouts of severe uncertainty. In equilibrium, agents use private signals as well as past equilibrium volatility to infer the likelihood of future states with Knightian uncertainty. Market volatility is generated both by noise and by the equilibrium implications of uncertainty-averse investors’ portfolio choices. This volatility is a signal of Knightian uncertainty to future generations, and leads to spirals: not only uncertainty leads to thin markets and, hence, high volatility; a period of sustained volatility leads agents to behave as uncertainty-averse agents, thereby raising future volatility.