We analyze hedging policies for a corporation that generates a foreign currency cash flow that is not known with certainty. We first show that if investors care about real rather than nominal cash flows, there are no "free lunches" due to the Siegal Paradox. THe profile of cash flows that accrue to the equity holders of the firm in various states is completely dtermined by the contractual value of the firm's foregin currency liability could always be chosen to be a foward contract to deliver the foreign currency. We obtain an intriguing result that the probability of bankruptcy for a film that attempts to minimize this probability is lower when htere is some uncertainty in the exchange rates than when there is no uncertainty in the exchange rates: the firm reduces the probability of bankruptcy by borrowing more than its financing needs through foregin currency borrowing alone and by investing the excess funds in domestic risk free securities. Our result provides a reationale for why firms amy choose not to invoice their products in a currency that has no inflation variability; this may also explalin why forms choose to write contracts in nominal rather than real terms.

Modelling the stock price processes of banks with large exposures to Latin American debt as a combination of diffusion and jump processes leads to a no-arbitrage pricing restriction which can be used to infer the implied market prices of Latin American debt.

Since lenders cannot observe the riskiness of the projects borrowers could choose, interest rates alone cannot be used as an instrument to discipline the borrowers. A credible threat to exclude borrowers who default more than a certain number of times from participating in the capital markets makes international debt contracts incentive compatible. Larger borrowers, since they get fewer chances to default, choose safer proejcts and are therefore charged smaller interest rates. Also, borrowers, after each successive default swtich to safer and safer projects which may result in smaller and smaller interest rates. This paper provides empirical evidence supporting these two predictions.

This paper examines how productivity changes affect real rates of return and price/earnings ratios in a small open economy. The model provides conditions under which increased productivity in a country’s traded goods sector causes prices of non-traded goods to increase relative to the price of traded goods. Under these conditions, real rates of interest decline and the production of certain non-traded durable goods (such as capital equipment and housing) immediately increase. This ‘overconstruction’ has two effects. First, the increase in capital relative to labor in these sectors increases the marginal product of labor and hence immediately causes an increase in wages and the prices of non-traded goods. Second, an ‘oversupply’ of capital goods and housing depresses their rental rates in the current period, thereby increasing their price to rental ratios or equivalently, their price/earnings ratios.

A model of security design based on the principle of information aggregation and alignment is used to show that (i) firms needing to finance their operations should issue different securities to different groups of investors in order to aggregate their disparate information and (ii) each security should be highly correlated (closely aligned) with the private information signal of the investor to whom it is marketed. This alignment reduces the adverse selection penalty paid by a firm with superior information. Adverse selection costs are often contingent on ex post publicly observable and contractible state variables such as exchange rates. In such cases, debt contracts are dominated by currency swaps and optimal securities, in general, are derivative contracts that are contingent on state variables that influence adverse selection costs. This is because the netting of cash flows in these derivative contracts, in effect, alters the state-by-state seniority of different claims in a desirable way.

The types of investments a firm undertakes will depend in part on what it expects the outcome of those investments to reveal about its skills, capabilities, and assets (i.e., its resources). We predict that a firm will specialize when young, then experiment in a new line of business for some time, and then either expand into a large, multisegment business or focus and scale up its specialized business. We derive several empirical implications for firm valuations and the reaction of stock prices to news about firm prospects. We also offer a novel explanation for the well-documented ‘‘diversification’’ discount.

We present a dynamic model of production in which a firm’s output increases when its managers share their information. Communication of ideas depends on the quality of the firm’s internal language. We prove that firms with richer languages (i.e., more organizational capital) will have higher market values. Organizational capital generates static complementarities among incumbents which implies that firms with richer languages will experience greater employee retention and higher wages. Dynamic complementarities between intertemporal investments in language generate long-run persistence in firm market-to-book and turnover ratios. We demonstrate that the optimal compensation of incumbents includes an earnings-insensitive component that is larger in firms with richer languages. In a simple model of mergers, we show that the most value-creating mergers are those between firms with highly disparate languages.

We provide a novel method for extracting estimates of realized pure price inflation from stock returns. The key is recognizing that pure price inflation should a®ect nominal returns of all traded assets by exactly the same amount. The popular Fama- French three-factor model is employed to purge stock returns of real economic factors. We uncover evidence that purchasing power parity holds quite well using the extracted inflation measures.

One issue in the argument about the merits of pegged and floating exchange rates involves the magnitude of transactions costs in the foreign exchange market under alternative exchange rate regimes. The higher the transactions costs, the greater the deterrence to international trade. Moreover, the higher these costs, the greater the scope for national monetary independence, and more fully the monetary authority in one country could follow policies that might cause the rates of return on assets denominated in its currency to di‹er from rates of return on comparable assets denominated in other currencies, for any given impact in inducing flows of short-term capital. In contrast, the lower the transactions costs in the foreign exchange market, the more the case for national monetary independence must rest on other deterrents to the shifts of funds among national financial centers, such as uncertainty about changes in exchange rates. Transactions costs in the foreign exchange market are not explicit, as in the markets with stan- dardized commissions like the home real estate market and organized security and commodity exchanges. Instead, transactions costs are implicit, as in the over-the-counter security market, and are collected by broker-dealers, primarily the large commercial banks, in the spreads between the prices at which they buy and sell foreign exchange. The transactions costs in the foreign exchange market may di‹er by the pair of currencies involved, by the size of the transaction, by the customer buying the foreign exchange, by the bank selling the foreign exchange, and even by the center in which a particular transaction such as the purchase of dollars with sterling occurs. However, from the point of view providing insights about the scope for monetary independence, the key consider- ation is the estimate of transactions costs incurred by those who pay the lowest costs – the banks in their transactions with each other. The next section discusses previous approaches to the measurement of transactions costs in the foreign exchange market. Then a new approach to estimate the transactions costs using futures prices is presented.

We present a simple, easy to implement methodology for pricing microfinance loans and loan guarantees using publicly available data on loan write-offs by Micro Finance Institutions (MFIs). Our methodology takes into account the selection bias inherent in available data in that MFIs that do not report loan write-off data are less likely to be better performers. Our quantitative analysis is consistent with pricing seen in a recent securitization deal. Our analysis suggests how securitization and loan guarantees can greatly expand the supply of funds for microfinance loans.