Frank Strobel

Marriage and the value of waiting

Frank Strobel — Mon, 13 Feb 2012 02:55:37 PST

Using a simple model where singles try to maximize their "pizazz", we examine the value of the option to give up single life in favor of marriage when singles' pizazz levels follow correlated geometric Brownian motions. We derive the critical level of relative pizazz levels that triggers the move to marriage and find that for relatively small (large) potential economies of scale in marriage, a single will generally be willing to get married if his/her prospective partner's pizazz is strictly higher (lower) than his/her own.

When to Leave a Monetary Union?

Frank Strobel — Mon, 13 Feb 2012 02:41:20 PST

Using a two-country model of monetary union where policymakers minimize the continuous-time equivalent of a Barro-Gordon-type loss function, we examine the value of the option of monetary disintegration when the national preference parameters associated with an inflationary surprise follow correlated geometric Brownian motions. We derive the critical level of the ratio of these parameters that triggers a move to monetary disintegration and find that a country will be willing to return to monetary independence only if the other country's relative inflation preferences are strictly, and potentially substantially, greater than a benchmark value depending on the cost of monetary disintegration alone.

International tax arbitrage, tax evasion and interest parity conditions

Frank Strobel — Mon, 13 Feb 2012 02:29:58 PST

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when there is some scope to evade taxes on foreign capital income. We derive tax-modified uncovered interest parity conditions and forward rates similar to the no-tax ones, but augmented by tax-induced “risk-premium” terms; covered interest parity conditions remain unaffected by the introduction of capital income taxes, a consequence of our approach of bounding tax-based arbitrage without restricting arbitrage per se.

International tax arbitrage, currency options and put-call parity conditions

Frank Strobel — Mon, 13 Feb 2012 02:04:34 PST

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation where foreign currency exposure can be hedged using forward contracts and a set of currency options. We obtain tax-modified option prices similar to the no-tax ones, but augmented by tax-induced "risk-premium" terms; tax-modified put-call parity conditions are derived that revert to their standard (no-tax) format if the respective marginal agents in the bond and option markets are in identical tax brackets.

Bank insolvency risk and Z-score measures with unimodal returns

Frank Strobel — Wed, 09 Feb 2011 06:04:16 PST

We specialize the established justification for using Z-scores as a risk measure reflecting a bank's probability of insolvency to the case where the bank's distribution of returns is unimodal, obtaining a refined upper bound of the probability of insolvency for this potentially useful special case.

Bank Insolvency Risk and Z-Score Measures: A Refinement

Frank Strobel — Wed, 02 Feb 2011 06:33:45 PST

We re-examine the probabilistic foundation of the link between Z-score measures and banks' probability of insolvency, offering an improved measure of that probability without imposing further distributional assumptions. The traditional measure of the probability of insolvency is upwardly biased as a consequence; however, it can be meaningfully reinterpreted as a measure capturing the odds of insolvency instead. We similarly obtain refined probabilistic interpretations of the commonly used simple and log-transformed Z-score measures; the log of the Z-score is shown to be negatively proportional to the log odds of insolvency, thus meaningfully defined on the domain of all real numbers, and consequently unproblematic to use in standard regression analysis.

Bank insolvency risk and different approaches to aggregate Z-score measures: a note

Frank Strobel — Fri, 10 Dec 2010 05:57:33 PST

We discuss to what extent existing approaches to the construction of aggregate Z-score measures capture the notion of systemic soundness, propose some alternative ones that could be just as informative and have potential complementary value, and illustrate how these different approaches compare using a data set of Organisation for Economic Co-operation and Development (OECD) commercial, cooperative and savings banks for the period 1994-2008.

Bank Equity Involvement in Industrial Firms and Bank Risk

Laetitia Lepetit et al. — Tue, 23 Nov 2010 01:29:17 PST

The regulatory framework in Europe does not prevent banks from taking large or controlling equity stakes in non-financial firms, potentially contributing to higher levels of bank risk and financial instability. Using a panel of European commercial banks for the period 2004-2008, we find that higher levels of equity positions in industrial firms and higher proportions of industrial firms where the bank is the majority shareholder lead to higher bank activity and insolvency risk. At low levels of shareholder protection, these risk measures are reduced when equity investments are held for longer, an effect attenuated at higher levels of shareholder protection.

Bank insolvency risk and aggregate Z-score measures: a caveat

Frank Strobel — Mon, 04 Oct 2010 03:50:42 PDT

We demonstrate that a popular approach to constructing (weighted) mean-based aggregate bank insolvency risk measures is inherently biased; we also suggest an alternative approach that avoids this problem.

Uncertainty and Switching in the Mortgage Market

Celine Gondat-Larralde et al. — Thu, 03 Dec 2009 03:28:46 PST

We examine when it might be optimal for borrowers to switch providers of debt products such as their mortgage, allowing in particular for the role of uncertainty by constructing a stylized real options model of the decision problem involved. We illustrate with numerical examples, and then calibrate the model for the U.K. mortgage market for the period Oct. 1998 to Mar. 2005; significant magnitudes of trigger levels can arise even when standard switching costs are zero, providing an additional, risk-related explanation to the inertia commonly observed in borrowers' product choices.

Does uncertainty matter for loan charge-offs?

Laetitia Lepetit et al. — Tue, 01 Dec 2009 10:05:24 PST

Using a stylized real options model, we show that discretion over the timing of charging off a non-performing loan could be economically justified when collateral values are uncertain and there is a chance of loan recovery. The implied hypothesis of an "uncertainty dependence" aspect in loan charge-offs is empirically tested and validated using a panel of European banks. A welfare-maximizing regulator might want to let banks pursue such discretionary loan charge-off behavior, with the problem of distinguishing it from alternative capital management and income smoothing objectives, while transparency-seeking accounting standards setters would presumably not.

Leaving EMU: a real options perspective

Frank Strobel — Tue, 01 Dec 2009 09:52:20 PST

The real option implicit in a country's decision of whether to leave an existing monetary union when there is uncertainty over the future benefits of this move is examined. The theoretical model used is calibrated for the current Euro-12 area by proxying policymakers' inflation preferences with unemployment rates and debt-to-GDP ratios. A robust group of countries is observed that would choose to remain within EMU consisting of Belgium, Finland, Greece and Italy; France and Spain loosely also belong to this core. Only Luxembourg would robustly want to leave EMU; Ireland and The Netherlands, however, complement that core closely.

International tax arbitrage, financial parity conditions and preferential capital gains taxation

Frank Strobel — Tue, 01 Dec 2009 09:48:55 PST

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when interest income and capital gains/losses are taxed differentially for some agents. We derive tax-modified uncovered interest parity conditions, Fisher conditions and forward prices similar to the no-tax ones, but augmented by tax-induced 'risk-premium' terms; covered interest parity and Fisher conditions remain unaffected by the introduction of capital income taxes as we bound tax-based arbitrage without restricting arbitrage per se.

Joining European Monetary Union: a real options perspective

Frank Strobel — Tue, 01 Dec 2009 09:44:11 PST

We examine the real option implicit in countries' decisions on whether to join a monetary union when future benefits of this move are uncertain. Our theoretical model is calibrated for the current Euro-12 area and EU-15 outs, proxying policymakers' inflation preferences with unemployment rates, debt-to-GDP and potential-to-actual-GDP ratios. The Euro-12 area is generally ready or close to wanting to expand, whereas the EU-15 outs are unready to make that move at present and have widely varying probabilities of wanting to do so in the future, depending on the measure used.

Monetary integration and inflation preferences: A real options analysis

Frank Strobel — Tue, 01 Dec 2009 09:38:02 PST

We use a two-country model where policymakers minimize Barro–Gordon-type loss functions over inflation, and inflation preferences follow geometric Brownian motions, to characterize and solve the optimal stopping problem describing a given country's decision of whether or not to pursue monetary integration with the other one, and derive the conditions under which monetary integration can, or will never, be an equilibrium outcome in our economy. We then carry out comparative statics analysis on the bounds characterizing these conditions and on the range of relative inflation preference parameters that support monetary integration in equilibrium, and illustrate with numerical examples.

Financial Fragility and Crisis Union in the Asia-Pacific Region

Frank Strobel — Tue, 01 Dec 2009 09:12:58 PST

We examine whether core ASEAN+3 countries might be interested in joining a financial "crisis union," allowing for the role of uncertainty by constructing a stylized real options model of the decision problem involved. We calibrate that model by proxying financial fragility with commonly used bank asset ratios and observe that, according to our criteria, a wider financial crisis union might be more attainable the more encompassing that grouping is; however, our results also reinforce the common perception of pervasive, possibly prohibitive, heterogeneity in these countries' banking and financial systems.