Financial Innovations and Macroeconomic Volatility
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Transcript of Financial Innovations and Macroeconomic Volatility
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Financial Innovations and Macroeconomic Volatility
Urban Jermann & Vincenzo QuadriniDiscussion by Wouter J. Denhaan
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Excellent new framework
• Both debt and equity as external finance (typically only one form of external finance)
• Aggregate shock is a change in the probability of “market loss”, which is like a change in ownership.
• No aggregate or idiosyncratic TFP shocks
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Excellent topic• Study cyclical properties of debt and equity• Study impact of financial innovation on
volatility of debt, equity, & output
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Nice set of results• Financial innovation can explain changes in
volatility• Innovations in equity markets seem more
important for reduction in volatility than innovations in debt markets
• Output much more volatile than measured TFP
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Link between theory and empirical result
• Paper tries to do too much, i.e., tries to match too many empirical results
• For some results, neither the empirical estimates nor the theoretical predictions are very robust to modifications
• Better to focus on key predictions of the paper
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Outline
• Simplified version of model• Cyclical behavior of debt and equity • Modifications of the model• Empirical findings
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A simplified version
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),,(
2
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A simplified version
)'1(''''
''..
)'1('''),,(
2
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pbkyb
kbykRbeets
pbkyebksV
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ebk
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First-Order Conditions
Rb
kyk
ee
)1(:'
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)1(1:1
p does not show up directly but comes in through
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Frictionless solution if = 0 & = R-1
Rb
ee
)1(:'
)1(1:
Equity can “undo” the friction on debt financing
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First-Order Conditions
cyclical-counter is issuanceequity net i.e., ,then
)0' (and ' if
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)1('')1(
1 1
e
yk
p
kye
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Theory on cyclical behavior of debt and equity
Substitutes• Jermann and Quadrini (2006)
– Debt pro-cyclical and equity countercyclical• Levy and Hennessy (2006)
– opposite
Complements• Covas and Denhaan (2006)
– Debt and equity pro-cyclical
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Theory on cyclical behavior of equity
Jerman and Quadrini (counter-cyclical):• No increase in need of funds during boom,
but obtaining debt financing becomes easier• Debt procyclical and equity countercyclicalLevy and Hennessy (pro-cyclical):• Obtaining equity becomes easier during
boom
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Theory on cyclical behavior of equityChoe, Masulis, and Nanda (pro-cyclical)• Adverse selection problem is relatively less
important during a boom• Equity issuance implies a transfer to debt holdings
(reduction in default probability and the value of this transfer is smaller during a boom)
• Covas and Denhaan (pro-cylical)• Standard debt contract with default Desire to
expand leads to tightening of bank break-even condition pro-cyclical equity issuance
• Counter-cyclical risk premium and equity issuance costs
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How would alternatives affect cyclical behavior of equity
What if lending rate increases with debt?• First-order condition for equity and capital not
affected• With standard debt contract & default & bankruptcy
costs, however, equity issuance would be procylcical
Cyclical exogeonous TFPCyclical equity issuance costsCyclical required rate of return on risky assets Alternative bargaining
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First-Order Conditions
increase very wellcouldequity Thus
)'(,',)'(,)'(,'
)1(''')'()'()'(1
1
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1
1
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ppppp
kypppep
kye
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Would modifications matterfor main prediction of model?
• Some might but several will not affect the result that easing of financial constraints reduces output volatility and increases debt and equity volatility
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Some of the Empirical ResultsJerman and Quadrini Empirical Fact #2“The debt exposure [debt/gdp] has increased during
the last 50 years”Frank and Goyal Stylized Fact #1“Over long periods of time, leverage [debt/assets] is
stationary”Frank and Goyal Stylized Fact #2“Over the past half century, the aggregate market-
based leverage ratio has been about 0.32. There have been surprisingly small fluctuations in this ratio from decade to decade.
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Some of the Empirical ResultsJerman and Quadrini Empirical Fact #3“Equity payouts [dividends minus equity issuance
scaled by GDP] are counter-cyclical”Covas and Denhaan• Dividends are pro-cyclical across firms• Aggregate results affected by largest top 1 to 5%
and by leveraged buyouts• If you take out mergers
– (Net) Equity issuance is pro-cyclical for most firms– (Net) Equity issuance counter-cyclical for top 1%– No clear pattern with aggregate data
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Minor Comments
• Is it costly to issue dividends/repurchase shares? As costly as issuing new equity
• Model is a bit of a black box• Does the representative firm ever issue equity?• How important are changes in asset prices?
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Concluding comments
• Optimal contracts: – One type of contract– No unique way of implementing it with cash reserves,
debt, & equity– Often odd properties like no defaults
• Fixed types of contracts:– Frictions too segmented. For example, couldn’t you
avoid friction on debt finance by also buying some equity?
– More helpful in understanding data