Optimal regulation, Heterogeneity in Macroeconomics, Macro-prudential Policies, Collateralized Borrowing, Financial Innovation
Abstract Global financial conditions increasingly shape derivative prices in small open economies, exposing domestic asset markets to externally determined risk valuations. We develop a theoretical framework in which domestic agents trade a productive asset alongside call and put options whose prices are determined in global markets. Because option payoffs depend on the equilibrium price of the domestically traded asset, private portfolio decisions generate price externalities and competitive equilibria are generally constrained inefficient. We represent this global influence through two complementary pricing specifications. The benchmark treats international option prices as exogenous summaries of global valuation conditions. The constrained-efficient allocation is implemented by state-contingent wedges whose signs depend on option moneyness and aggregate derivative positions. The extension keeps these global valuation conditions exogenous but allows option prices to respond endogenously to domestic asset prices through derivative payoffs. The optimal wedge then also depends on relative global-domestic state valuations and may be weakened, reversed, or eliminated. Finally, we embed both specifications in a stationary overlapping-generations economy and show that their regulatory implications survive in an ongoing economy.
Slides (for the presentation at the 57th Annual MMF conference)
Financial innovation, Collateral hedging and Macro-prudential policies
This paper features an economy with incomplete markets, collateralised lending and investors that hold heterogeneous beliefs about the states of the world. Financial innovation takes the form of collateral hedging, which enables collateral protection insurance (CPI) contracts together with existing investment in capital to back loans. The contribution of this paper is to characterize the effectiveness of two macro-prudential policies, namely higher collateral requirements on CPI or capital, towards mitigating default friction and maximizing social welfare. The degree of belief disagreement is an important factor determining the effectiveness of policy. When disagreement is extreme, then the policy via financial innovation is not effective, unless it is not costly, and macro-prudential interventions call for higher collateral requirements on capital; while under moderate levels of disagreement, increasing collateral requirements on capital is not effective, and policy interventions call for financial innovation.
Slides (for the presentation at the 7th Annual MMF Ph.D. conference)
Optimal macro-prudential policies with Endogenous collateral constraints (with Nikolaos Kokonas)
We characterize optimal macro-prudential policies in economies with incomplete markets and collateral constraints. Macro-prudential policies take the form of taxes or subsidies on asset trading. We distinguish between economies with exogenous and endogenous collateral constraints. Optimal policy in the latter economies is shaped by pecuniary externalities arising from the endogeneity of margin requirements on borrowing, whereas this channel is muted in the economy with exogenous constraints. In a quantitative exercise, we show that the level and sign of the tax schedules between economies may differ as collateral constraints become looser through income perturbations; while the tax schedule responds non-linearly to rising uncertainty of collateral asset returns in the exogenous margin model, as opposed to the smooth response of the tax schedule to rising uncertainty in the economy with endogenous margins.
Slides (for the Theories and Methods in Macro Workshop)
Financial innovation, Macro-prudential policies and Leverage cyclesÂ
In the wake of the 2008 global financial crisis, the Federal Reserve has initiated various macro-prudential policies to stabilize asset prices and stimulate the real economy. These policies achieved the targets during the recession in 2011, but failed in this task during the recovery in 2014. This paper rationalizes these observations on the effectiveness of macro-prudential policies in a three-period general-equilibrium model with incomplete markets, heterogeneous agents and endogenous leverage. The crucial insight is the interaction between belief heterogeneity and financial innovation at equilibrium. Financial innovation, as an additional macro-prudential tool, alongside collateral requirements on borrowing, takes the form of collateral protection insurance (CPI) contracts. The results show that macro-prudential policies which stabilize asset prices, may not improve social welfare. Specifically, policies that regulate higher collateral requirements stabilize asset prices, smooth the leverage cycle, but reduce social welfare, when belief heterogeneity is small. In contrast, the introduction of CPI contracts increases the dispersion of asset prices across date events, exacerbating the leverage cycle, but improves social welfare, when belief heterogeneity is large.
Slides (for the presentation in the XXIX European Workshop on Economic Theory )