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- Volume 11, 2019
Annual Review of Financial Economics - Volume 11, 2019
Volume 11, 2019
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Robert C. Merton and the Science of Finance
Vol. 11 (2019), pp. 1–20More LessStarting with his 1970 doctoral dissertation and continuing to today, Robert C. Merton has revolutionized the theory and practice of finance. In 1997, Merton shared a Nobel Prize in Economics “for a new method to determine the value of derivatives.” His contributions to the science of finance, however, go far beyond that. In this article I describe Merton's main contributions. They include the following:
- 1. The introduction of continuous-time stochastic models (the Ito calculus) to the theory of household consumption and investment decisions. Merton's technique of dynamic hedging in continuous time provided a bridge between the theoretical complete-markets equilibrium model of Kenneth Arrow and the real world of personal financial planning and management.
- 2. The derivation of the multifactor Intertemporal Capital Asset Pricing Model (ICAPM). The ICAPM generalizes the single-factor CAPM and explains why that model might fail to properly account for observed market excess returns. It also provides a theory to identify potential forward-looking risk premia for use in factor-based investment strategies. It is therefore both a positive and normative theory.
- 3. The invention of Contingent Claims Analysis (CCA) as a generalization of option pricing theory. CCA applies the technique of dynamic replication to the valuation and risk management of a wide range of corporate and government liabilities. Merton's CCA model for the valuation and analysis of risky debt is known among scholars and practitioners alike as the Merton Model.
- 4. The development of financial engineering, which employs CCA to design and produce new financial products. Merton was the first to apply CCA to analyze government guaranty programs such as deposit insurance, and to suggest improvements in the way those programs are managed. He and his students have applied his insights at both the micro and macro policy levels.
- 5. And finally, the development of a theory of financial intermediation that explains and predicts how financial systems differ across countries and change over time. Merton has applied that theory, called functional and structural finance, to guide the design and regulation of financial systems at the levels of the firm, the industry, and the nation. He has also used it to propose reforms in pensions, sovereign wealth funds, and macrostabilization policy.
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The Anatomy of Distressed Debt Markets
Vol. 11 (2019), pp. 21–37More LessOver the last 30 years, the distressed debt market has come a long way and is now a legitimate investment asset class, albeit with periodic dramatic activity. Despite the benign credit cycle in US markets since the last great financial crisis, there are still more than 200 financial institutions in the United States, and a large number operating in other countries, such as Italy, Brazil, and India, specializing in investment in distressed and defaulted bonds and nonperforming loans. We document this novel and intriguing investment market, with a discussion of size, strategies, and performance. We also present new empirical results on pre- and postdefault experience, leveraging our unique databases on bond and loan prices and our indexes of performance of defaulted bonds and bank loans. The results show that the investment performance in distressed debt is not particularly impressive over the entire sample (1987–2016). For the last 10 years (2006–2016), however, the results are much better for overall outperformance, especially those using several strategies with respect to the seniority of the debt and market timing. This is due perhaps to favorable changes for creditors in the US bankruptcy code in 2005.
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A Review of China's Institutions
Vol. 11 (2019), pp. 39–64More LessThe spectacular economic growth in China during the past four decades has inspired a great deal of research to understand China's unconventional growth path. This review focuses on recent developments in China's institutions, financial markets, innovations, and government–business relations in the context of their roles in supporting China's growth. The government's role in finance and the economy has advantages and disadvantages in comparison to developed markets in the West. Alternative financing channels and governance mechanisms, rather than markets and banks, continue to promote growth in the most dynamic sectors of the economy, despite the fact that China has passed the early-development stage. More research is needed to understand the Chinese experience and determine whether similar mechanisms are behind the growth of other economies.
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Municipal Bond Markets
Vol. 11 (2019), pp. 65–84More LessThe effective functioning of the municipal bond market is crucial for the provision of public services, as it is the largest capital market for state and municipal issuers. Prior research has documented tax, credit, liquidity, and segmentation effects in municipal bonds. Recent regulatory initiatives to improve transparency have made granular trade data available to researchers, rendering the municipal bond market a natural laboratory for the study of financial intermediation, asset pricing in decentralized markets, and local public finance. Trade-by-trade studies have found large trading costs, contemporaneous price dispersion, and other deviations from the law of one price. More research is required to understand optimal market design and the impact of post-crisis regulation, sustainability, and financial technology.
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Measuring the Cost of Bailouts
Vol. 11 (2019), pp. 85–108More LessThis review develops a theoretical framework that highlights the principles governing economically meaningful estimates of the cost of bailouts. Drawing selectively on existing cost estimates and augmenting them with new calculations consistent with this framework, I conclude that the total direct cost of the 2008 crisis-related bailouts in the United States was on the order of $500 billion, or 3.5% of GDP in 2009. The largest direct beneficiaries of the bailouts were the unsecured creditors of financial institutions. The estimated cost stands in sharp contrast to popular accounts that claim there was no cost because the money was repaid, and with claims of costs in the trillions of dollars. The cost is large enough to suggest the importance of revisiting whether there might have been less expensive ways to intervene to stabilize markets. At the same time, it is small enough to call into question whether the benefits of ending bailouts permanently exceed the regulatory burden of policies aimed at achieving that goal.
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The Household Finance Landscape in Emerging Economies
Vol. 11 (2019), pp. 109–129More LessWe survey the household finance landscape in emerging economies. We first present statistics on household balance sheets from official microsurveys in countries constituting 45% of the global population: China, India, Bangladesh, the Philippines, Thailand, and South Africa. We contrast these patterns with those in data from advanced economies. We then survey the nascent literature on household finance in emerging economies and discuss areas of overlap with the better-established literature on household finance in advanced economies, as well as the large body of literature on development finance. We highlight useful directions for future research.
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Risk Adjustment in Private Equity Returns
Vol. 11 (2019), pp. 131–152More LessThis article reviews empirical methods to assess risk and return in private equity. I discuss data and econometric issues for fund-level, deal-level, and publicly traded partnerships data. Risk-adjusted return estimates vary substantially by method, time period, and data source. The weight of evidence suggests that, relative to a similarly risky investment in the stock market, the average venture capital (VC) fund earned positive risk-adjusted returns before the turn of the millennium, but net-of-fee returns have been zero or even negative since. Average leveraged buyout (BO) investments have generally earned positive risk-adjusted returns both before and after fees, compared with a levered stock portfolio. Based on an expanded set of risk factors from the literature, VC resembles a small-growth investment, while BO loads mostly on value. I also discuss the empirical evidence on liquidity and idiosyncratic volatility risks.
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Commercial Real Estate as an Asset Class
Vol. 11 (2019), pp. 153–171More LessWe survey the properties of commercial real estate (CRE) as an asset class. We first illustrate its importance relative to the US economy and to other asset classes. We then discuss CRE ownership patterns over time. While the academic literature has emphasized Real Estate Investment Trusts, about two-thirds of the value of CRE is owner occupied. We next study the return properties of CRE indices and discuss what is known about the returns to individual properties. We briefly discuss CRE debt before turning to property derivatives. Finally, we consider how including CRE in a portfolio affects the portfolio's performance.
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Direct Versus Iterated Multiperiod Volatility Forecasts
Vol. 11 (2019), pp. 173–195More LessMultiperiod-ahead forecasts of returns’ variance are used in most areas of applied finance where long-horizon measures of risk are necessary. Yet, the major focus in the variance forecasting literature has been on one-period-ahead forecasts. In this review, we compare several approaches of producing multiperiod-ahead forecasts within the generalized autoregressive conditional heteroscedastic (GARCH) and realized volatility (RV) families—iterated, direct, and scaled short-horizon forecasts. We also consider the newer class of mixed data sampling (MIDAS) methods. We carry the comparison on 30 assets, comprising equity, Treasury, currency, and commodity indices. While the underlying data are available at high frequency (5 minutes), we are interested in forecasting variances 5, 10, 22, 44, and 66 days ahead. The empirical analysis, which is performed in sample and out of sample with data from 2005 to 2018, yields the following results: Iterated GARCH dominates the direct GARCH approach, and the direct RV is preferred to the iterated RV. This dichotomy of results emphasizes the need foran approach that uses the richness of high-frequency data and, at the same time, produces a direct forecast of the variance at the desired horizon, without iterating. The MIDAS is such an approach, and unsurprisingly, it yields the most precise forecasts of variance both in and out of sample. More broadly, our study dispels the notion that volatility is not forecastable at long horizons and offers an approach that delivers accurate out-of-sample predictions.
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Debt Covenants and Corporate Governance
Vol. 11 (2019), pp. 197–219More LessWe review the recent theoretical and empirical literature on debt covenants with a particular focus on how creditor governance after covenant violations can influence the borrower's corporate policies. From the theoretical literature, we identify the key trade-offs that help explain the observed heterogeneity in covenant types, inclusion, likelihood of violation, and postviolation renegotiation flexibility. Empirically, we first review the literature that deals with ex ante evidence on covenant design and the various factors that influence covenant design; we next review the ex post evidence on the impact of technical covenant violations on the borrower. We then discuss limitations of the existing theoretical and empirical studies and conclude with some directions for future research in this burgeoning area.
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Technological Innovation, Intangible Capital, and Asset Prices
Vol. 11 (2019), pp. 221–242More LessWe review research on the asset pricing implications of models with innovation and intangible capital. In these models, technological innovation shocks propagate differently than standard total factor productivity shocks—and therefore have qualitatively distinct asset pricing implications. We discuss recent approaches to measuring intangible capital and innovation, many of which rely on the prices of financial securities. Last, we review models that explore the economic differences between intangible and innovation relative to other forms of investments—focusing on the role of human capital and cash-flow appropriability.
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Digital Disruption in Banking
Vol. 11 (2019), pp. 243–272More LessThis review surveys technological disruption in banking, examining its impact on competition and its potential to increase efficiency and customer welfare. It analyzes the possible strategies of the players involved—incumbents and FinTech and BigTech firms—and the role of regulation. The industry is facing radical transformation and restructuring, as well as a move toward a customer-centric platform-based model. Competition will increase as new players enter the industry, but the long-term impact is more open. Regulation will decisively influence to what extent BigTech will enter the industry and who the dominant players will be. The challenge for regulators will be to keep a level playing field that strikes the right balance between fostering innovation and preserving financial stability. Consumer protection concerns rise to the forefront.
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