- “A Theory of Debt Accumulation and Deficit Cycles”
This paper introduces a tractable model of sovereign debt where governments cannot default strategically, but face intertemporal tradeoffs between (i) preferring more primary deficits to less and (ii) avoiding costly defaults. Governments run deficits when debt and, then, the marginal costs of increasing debt are low. However, after an extended period of debt accumulation, default probabilities begin to rise quickly, and so do the marginal costs of running debt. Eventually, debt reaches a critical level relative to the size of the economy, a fiscal tipping point, after which debt accumulation stops, with governments cycling between deficits and surpluses, until perhaps a time of default. The main conclusions are that (i) fiscal tipping points typically occur when distance-to-default is between 10% and 20%; (ii) tipping points are pushed back in a stable macroeconomic environment, such that default premiums are higher in countries that implement austerity earlier and remain positive even when exogenous risk is very small (two “volatility paradoxes”); (iii) liquidity conditions and fiscal reforms may affect default probabilities in an ambiguous way; (iv) fiscal austerity may arrive too late: “debt intolerance” arises around the fiscal tipping point.
CEPR Discussion Paper No. 16329Download Download presentation
- BOOK: Metamorfosi: 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. Work in progress.
- “Uncertainty and Volatility in Financial Markets”
with Francesco Sangiorgi (Frankfurt School of Finance & Management)
This paper is a survey of work on financial market volatility, Knightian uncertainty, and their interlinks. We deal with both theoretical and empirical models and attempt at explaining how these models link to market adoptions of instruments that allow to trade developments in volatility. Work in progress.