Banking Reforms for the 21st Century: A Perfectly Stable Banking System Based on Financial Innovations*
Nai-Fu Chen(University of California)

Although bank loans themselves are somewhat illiquid because of private information, most of their cashflows are not. Recent financial innovations allow commercial loans to be liquefied via credit derivatives and actual and synthetic securitizations. The loan originating bank holds the remaining illiquid equity tranche containing the concentrated credit risk, private information rent and the ‘excess spread’ that incentivize the bank to continue to monitor and service the loans. Empirically, we find that the average size of the equity tranche is about 3% for the representative commercial loan portfolios in our sample. The liquefaction of bank loans makes possible a banking system that restricts the guaranteed accounts to be backed by 100% reserves and the non-guaranteed deposits to be backed by liquid securitized loan tranches, while retaining the deposit-lending synergy. Such a system is perfectly safe without deposit insurance and it renders banks bankruptcy-remote without sacrificing a bank’s traditional role as a financial intermediary.

*This paper started as joint work with Merton Miller based on our meeting with the Hong Kong Monetary Authority. This version of the paper was completed after Merton Miller passed away and the current authorship reflects the wishes of his estate. We thank Jeremy Berkowitz, Bruce Brittain, Yuk-shee Chan, Ellen Chen, Stijn Claessens, Doug Diamond, Greg Duffee, Eugene Fama, Jie Gan, Vidhan Goyal, Diane Lam, Marie Lam, Steve Lang, Andrew Lui, Elaine Ng, James O’Brien, David Stanley, Neal Stoughton, Juichi Takeuchi, Lee Thomas, Powell Thurston, Irene Tsao, Ram Willner, Patrick Wright, Michael Ye and seminar participants at the Bank of Finland, HEC, INSEAD, Swedish School of Economics and Business Administration, Hong Kong University of Science and Technology and UC Irvine for helpful comments, Moody’s and Standard and Poor’s for generously sharing their data bases, and Daniela Balkanska and Gaiyan Zhang for research assistance.

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Short Rate Dynamics and Regime Shifts*
Hai Tao Li(Stephen M. Ross School of Business, University of Michigan)
Yuewu Xu(Graduate School of Business, Fordham University)

We characterize the dynamics of the US short-term interest rate using a Markov regime-switching model. Using a test developed by Garcia, we show that there are two regimes in the data: In one regime, the short rate behaves like a random walk with low volatility; in another regime, it exhibits strong mean reversion and high volatility. In our model, the sensitivity of interest rate volatility to the level of interest rate is much lower than what is commonly found in the literature. We also show that the findings of nonlinear drift in Aït-Sahalia and Stanton, using nonparametric methods, are consistent with our regime-switching model.

*We thank Yacine Aït-Sahalia, Warren Bailey, Yongmiao Hong, Jonathan Ingersoll, Robert Jarrow, and seminar participants at Cornell University and the American Finance Association Meeting for helpful comments. We are especially grateful to the editor, Henry Cao, and an associate editor for insightful comments and suggestions. We also thank Yacine Aït-Sahalia for providing the Eurodollar interest rate data. We are responsible for any remaining errors.

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Estimation Uncertainty and the Equity Premium*
Hong Yan(Department of Finance, Moore School of Business, University of South Carolina)

This paper studies a dynamic equilibrium model of asset prices in a partially observable exchange economy. It shows that the precautionary savings motive in response to estimation uncertainty can dominate the risk aversion effect, resulting in the reduction of the equity premium over short horizons. This exacerbates the equity premium puzzle. Over longer holding horizons, however, estimation uncertainty does induce higher risk premiums on equity over risk-free coupon bonds of matching maturities, as long-term bond yields are lowered due to the precautionary savings effect.

*An earlier version containing part of the content of this paper was circulated under the title ‘Uncertain Growth Prospects, Estimation Risk and Asset Prices.’ For helpful comments and guidance, I would like to thank David Chapman, Domenico Cuoco, Alexander David, Greg Duffee, Hayne Leland, Terry Marsh, David Romer, Mark Rubinstein, Pietro Veronesi, Fernando Zapatero and participants at the AFA meeting in Boston and at seminars at the Federal Reserve Board, Georgetown University, Hong Kong University of Science and Technology, Rice University, University of California at Berkeley, University of California at Irvine, University of Texas at Austin, University of Toronto, University of Utah, and the Wharton School. All errors remain my own.

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Common Risk Factors Versus a Mispricing Factor of Tokyo Stock Exchange Firms: Inquiries into the Fundamental Value Derived from Analyst Earnings Forecasts*
Keiichi Kubota(Chuo University)
Kazuyuki Suda(Waseda University)
Hitoshi Takehara(Waseda University)

We search for common factors and/or a mispricing factor for Tokyo Stock Exchange firms. We utilize the Edwards–Bell–Ohlson model to compute the firms’ fundamental value and divide this value by the firms’ market price to construct a new variable called a ‘value-to-price ratio’ (VPR). We find that this VPR variable can generate abnormal returns even after adjusting for the risk factors related to portfolio style differences. To find out whether it is indeed a risk factor or simply a characteristic, we construct return difference portfolios of the high VPR stocks minus the low value-to-price stocks and call this portfolio the upward-forecast minus downward-forecast (UMD) factor. Fama and MacBeth test indicate that the risk premium for this UMD factor is positive. The best model in terms of the adjusted R2 value is the four-factor model in which the UMD factor is added to the Fama and French three factors. GMM Euler condition tests reveal that the UMD factor helps to price assets and that the four-factor model is not rejected. We conclude the VPR variable contains new information content that is not contained in the conventional Fama and French’s three factors.

*The authors thank Nai-fu Chen (then editor of this journal) for his editing suggestions and anonymous referees for helpful comments. This paper was presented at annual meetings of the 2001 Asia-Pacific Finance Association (a former body of the Asian Finance Association), the 2001 Nippon Finance Association, and the 2002 European Finance Association as Berlin Discussion Paper Series as well as at Finance Workshop at Hong Kong University of Science and Technology. The authors thank Kevin Chen, Sheridan Titman, Eiko Tsujiyama, John K. C. Wei, and Chu Zhang for their useful comments and discussion. The authors acknowledge financial support from a Grant-in-Aid for Scientific Research by the Japan Society for the Promotion of Science. All remaining errors are our own.

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Effect of Price Limits: Initial Public Offerings versus Seasoned Equities*
Yong H. Kim(Department of Finance, University of Cincinnati)/J. Jimmy Yang(Department of Finance, Oregon State University)

In this paper, we examine the effect of price limits on initial public offerings (IPOs) using Taiwanese data. On average, it takes 6.24 days for IPOs to reach their equilibrium prices in the presence of a 7% price limit. We compare IPOs with their industry- and size-matched seasoned equities (MSEs) and observe higher volatility levels on subsequent days for IPOs than for MSEs. However, the higher volatility decays within 2 days. Lower price limits interfere with trading and lead to higher trading activity on subsequent days for IPOs than for MSEs. We also observe delayed price discovery for both IPOs and MSEs. Overall, our results provide evidence about the effect of price limits on IPOs and generate important regulatory implications for countries imposing price limits on IPOs.

*We would like to thank Francois Derrien, Manjeet Dhatt, Mike Ferguson, Brian Hatch, Takashi Kaneko, Ken Kim, Tai Ma, Gina Nicolosi, Yair Orgler, Dick Pettway, Yasuhiko Tanigawa, Kent Womack, and participants in seminars at Bowling Green State University and University of Cincinnati for their helpful comments. Earlier versions have been also presented at the Asia Pacific Finance Association, the PACAP/FMA, Multinational Finance Society, FMA, FMA Europe, the Korea–America Finance Association and Allied Korean Associations for Financial Studies, the Global Finance, and the Midwest Finance Association conferences. We also thank Vincent Chen and Vincent Lin for providing data. Finally, partial funding from the George Scull Fund through the University of Cincinnati Foundation is gratefully acknowledged.

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Does the More Risk-Averse Investor hold a Less Risky Portfolio?*
George Wong(School of Accounting and Finance, The Hong Kong Polytechnic University)

We study the suitability of using absolute risk aversion as a measure of willingness to take risk in the Arrow–Debreu portfolio framework. We define a global measure of risk for the Arrow–Debreu portfolio, which is measured by the sensitivity of an individual’s Arrow–Debreu portfolio payoff to the change in the market return. We call this measure ‘conservatism’ and show that the concept of ‘more conservative’ is stronger than that of ‘more risk-averse.’ A higher absolute risk aversion is only necessary but not sufficient to induce a less risky Arrow–Debreu portfolio. Our results not only challenge the well-accepted notion that a more risk-averse investor holds a less risky portfolio, but also suggest a stronger measure – conservatism – for evaluating the riskiness of portfolio.

*The major part of the work in this paper was done when I was pursuing my Ph.D. study. I am greatly indebted to the numerous contributions made by my supervisors: Christine Brown, Paul Kofman and Richard Stapleton. Special thanks are due to Bruce Grundy for his contructive advise which has significantly improved the paper. I also thank Qi Zeng and seminar participants at the University of Melbourne and the University of New South Wales for their helpful comments.

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