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Abstract:
This paper draws upon the modern science of finance to address several important practical issues in personal finance. Chief among these is how much to save for retirement and how to invest those savings. The paper suggests ways that advances in the theory of finance combined with innovations in financial contracting technology might be used to improve social welfare by designing and producing a new generation of user-friendly life-cycle products for consumers. It contrasts the old Markowitz single-period paradigm of efficient diversification with a new Mertonian paradigm that takes account of multi-period hedging, labor supply flexibility, and habit formation.

life-cycle finance, personal investing, personal financial planning, Markowitz paradigm, Mertonian paradigm

Abstract:
This paper examines the proposition that investing in common stocks is less risky the longer an investor plans to hold them. If the proposition were true, then the cost of insuring against earning less than the risk-free rate of interest would decline as the length of the investment horizon increases. The paper shows that the opposite is true even if stock returns are "mean-reverting" in the long run. The case for young people investing more heavily in stocks than old people cannot therefore rest solely on the long-run properties of stock returns. For guarantors of money-fixed annuities, the proposition that stocks are a better hedge the longer the maturity of their obligations is unambiguously wrong.

Stocks in the long run, hedge, hedging, inflation hedge

Abstract:
This paper examines the proposition that investing in common stocks is less risky the longer an investor plans to hold them. If the proposition were true, then the cost of insuring against earning less than the risk-free rate of interest should decline as the length of the investment horizon increases. The paper shows that the opposite is true even if stock returns are "mean-reverting" in the long run. The case for young people investing more heavily in stocks than old people cannot, therefore, rest solely on the long-run properties of stock returns. For guarantors of money-fixed annuities, the proposition that stocks in their portfolio are a better hedge the longer the maturity of their obligations is unambiguously wrong.

Abstract:
This paper proposes a new approach to investing for retirement that takes advantage of recent market innovations and advances in finance theory to improve the risk/reward opportunities available to individual investors before and after retirement. The approach introduces three new elements:

- It uses inflation-protected bonds to hedge a minimum standard of living after retirement.

- It takes account of a person's willingness to postpone retirement.

- It uses option "ladders" to lever growth in retirement income.

Inflation-protected bonds, flexible retirement, option ladders

Abstract:
This paper reviews and analyzes how the practice of investment management has been affected by advances in finance theory, market innovations, and technological progress. The first section presents an overview of the development of capital markets and financial institutions since 1950, and the next section makes some predictions about trends for the future. It argues that over the next few decades, as retirement-income systems around the world make the transition from "pay-as-you-go" social security to self-directed retirement accounts, the investment-management business is likely to undergo a radical transformation. There will be growing demand for customized, integrated investment and insurance products, and financial engineering will play a pivotal role in meeting this demand. The final section draws some implications of the analysis for the role of government in overseeing and facilitating the transformation of both the retirement-income system and the investment-management business.

Abstract:
This paper analyzes how the practice of investment management has been affected over the past 45 years by technological progress, market innovations, and advances in finance theory. Over the next few decades, as retirement-income systems around the world make the transition from "pay-as-you-go" social security to self-directed retirement accounts, the investment-management business is likely to undergo a radical transformation. There will be a growing demand for customized, integrated investment and insurance products. Financial engineering will play a major role in this transformation.

Abstract:
This paper examines the empirical question of whether systematic equity risk of U.S. firms as measured by beta from the Capital Asset Pricing Model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet, and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of Pension Benefit Guaranty Corporation further clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment will typically bias upwards estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known U.S. companies. This bias can result in positive net-present-value projects being rejected.

Abstract:
This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

Defined Benefit Pension Plan, Market Efficiency, Cost of Capital, Capital Budgeting

Abstract:
This paper proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities. It is a synthesis of the neoclassical, neo-institutional, and behavioral perspectives. Neoclassical theory is an ideal driver to link science and global practice in finance because its prescriptions are robust across time and geopolitical borders. By itself, however, neoclassical theory provides little prescription or prediction of the institutional structure of financial systems that is, the specific kinds of financial intermediaries, markets, and regulatory bodies that will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms. The neoclassical model therefore offers important, but incomplete, guidance to decision makers seeking to understand and manage the process of institutional change. In accomplishing this task, the neo-institutional and behavioral perspectives can be very useful. In this proposed synthesis of the three approaches, functional and structural finance (FSF), institutional structure is endogenous. When particular transaction costs or behavioral patterns produce large departures from the predictions of the ideal frictionless' neoclassical equilibrium for a given institutional structure, new institutions tend to develop that partially offset the resulting inefficiencies. In the longer run, after institutional structures have had time to fully develop, the predictions of the neoclassical model will be approximately valid for asset prices and resource allocations. Through a series of examples, the paper sets out the reasoning behind the FSF synthesis and illustrates its application.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
This paper proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities. It is a synthesis of the neoclassical, neo-institutional, and behavioral perspectives. Neoclassical theory is an ideal driver to link science and global practice in finance because its prescriptions are robust across time and geopolitical borders. By itself, however, neoclassical theory provides little prescription or prediction of the institutional structure of financial systems - that is, the specific kinds of financial intermediaries, markets, and regulatory bodies that will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms. The neoclassical model therefore offers important, but incomplete, guidance to decision makers seeking to understand and manage the process of institutional change. In accomplishing this task, the neo-institutional and behavioral perspectives can be very useful.

In this proposed synthesis of the three approaches, functional and structural finance (FSF), institutional structure is endogenous. When particular transaction costs or behavioral patterns produce large departures from the predictions of the ideal frictionless neoclassical equilibrium for a given institutional structure, new institutions tend to develop that partially offset the resulting inefficiencies. In the longer run, after institutional structures have had time to fully develop, the predictions of the neoclassical model will be approximately valid for asset prices and resource allocations. Through a series of examples, the paper sets out the reasoning behind the FSF synthesis and illustrates its application.

financial system; financial structure

Abstract:
As pension plans in the U.S. and other countries shift from defined benefit to defined contribution plans, employees are being asked to bear investment risk formerly borne by employers and/or governments. Using a simulation model, this paper examines the performance of alternative investment strategies and products over the working life of a hypothetical employee. The results illustrate the uncertainty inherent in standard investment products and suggest the need for new products that would help employees manage investment risk. The paper explores the performance of investment products that provide a floor on the value of the worker's investment over some period of time, say five years, and also provide some share of the upside of the equity market. These products appear to work well; for example, workers who invest their annual retirement contributions in a series of five-year insured products appear to have a higher chance of achieving their retirement income target than if they were to invest the same amount in the S&P 500 index.

Abstract:
Many participants in self-directed retirement plans (401k, IRA, etc.) do not know enough about investing to choose rationally among alternatives. Others may know enough, but find it unpleasant or too time-consuming. Target-date funds (TDFs), also known as life-cycle funds, are being offered as a simple solution to their dilemma. A TDF is a "fund of funds" diversified across stocks, bonds, and cash with the feature that the proportion invested in stocks is automatically reduced as time passes. Empirical evidence suggests that a simple TDF strategy would be an improvement over the choices currently made by many uninformed plan participants. This paper explores one way to achieve an even greater improvement. Using a compact continuous-time optimization model, we characterize a person for whom a TDF strategy would be optimal: a "natural TDF holder." We then show that the TDF strategy may be far from optimal for people who — although of the same age — differ from the natural TDF holder in their risk aversion or exposure to human-capital risk. To bring such plan participants much closer to their optimal strategy it is enough to add a second simple investment alternative — a safe fund matched to their time horizon. Participants with the same time horizon could then choose (or be advised to choose) either the TDF or the safe target-date fund depending on their risk aversion and human-capital risk. We find that people who are very risk averse and who have a high exposure to market risk through their labor income would experience a substantial gain in welfare from being offered a safe target-date fund rather than a risky one. Recent empirical research suggests that human-capital betas change over one's working career. They are typically quite high during the early years when human capital represents the largest part of total wealth for most people, and they decline with age. To reflect gradual changes in human capital risk over the life-cycle from predominantly "stock-like" to mostly "bond-like," TDFs should switch from a "linear" strategy to a "hump-shaped" strategy with respect to age.

Life-Cycle Planning under Uncertainty, Risky Labor Income, Target-Date Retirement Funds, Pension Design

Abstract:
This paper examines individual asset-allocation behavior using data from a unique survey containing information on the composition of the respondents' total asset holdings both inside and outside of their retirement accounts. We find that individual asset allocations are consistent with the recommendations of expert practitioners and with the prescriptions of economic theory. The survey respondents maintain in cash and near-cash investments a proportion of their wealth that declines as wealth increases. They hold these safe assets outside of their retirement accounts. The proportion of total assets that they hold in equities declines with age and rises with wealth. However, respondents do not appear to manage their assets across retirement and non-retirement accounts to maximize tax efficiency.

Abstract:
During the past twenty years, swap contracts have become key financial "adapters" linking diverse national financial systems to the global financial network. Today banks and investment companies around the world use swaps extensively to manage their currency, interest-rate, and equity-market risks and to lower their transaction costs. Yet pension funds, which have grown rapidly over that same 20-year period, hardly use swaps at all. This paper suggests how pension funds could use swaps to achieve the risk-sharing benefits of broad international diversification and hedging while avoiding the "flight" of scarce domestic capital to other countries. The paper also shows how swaps can be used to lower the risks of expropriation and to lower the other transaction costs of investing in other countries.

Swap, pension fund, international diversification

Abstract:
During the past twenty years, swap contracts have become key financial "adapters" linking diverse national financial systems to the global financial network. Today banks and investment companies around the world use swaps extensively to manage their currency, interest-rate, and equity-market risks and to lower their transaction costs. Yet pension funds, which have grown rapidly over that same 20-year period, hardly use swaps at all. This paper suggests how pension funds could use swaps to achieve the risk-sharing benefits of broad international diversification and hedging while avoiding the "flight" of scarce domestic capital to other countries. The paper also shows how swaps can be used to lower the risks of expropriation and to lower the other transaction costs of investing in other countries.

Pensions, diversification, risk-sharing, swaps

Abstract:
How much should a family save for retirement and for the kids' college education? How much insurance should they buy? How should they allocate their portfolio across different assets? What should a company choose as the default asset allocation for a mandatory retirement saving plan? We believe that the life-cycle model developed by economists over the last fifty years provides guidance for making such decisions. The theory teaches us to view financial assets as vehicles for transferring resources across different times and outcomes over the life cycle, and that perspective allows households and planners to think about their decisions in a logical and rigorous way. This paper lays out and illustrates the basic analytical framework from the theory in nonmathematical terms, with the aim of providing guidance to financial service providers, consumers, and policymakers.

Abstract:
The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy. CCA provides a natural framework for analysis of mismatches between an entity's assets and liabilities, such as currency and maturity mismatches on balance sheets. Policies or actions that reduce these mismatches will help reduce risk and vulnerability. It also provides a new framework for sovereign capital structure analysis. It is useful for assessing vulnerability, policy analysis, risk management, investment analysis, and design of risk control strategies. Both public and private sector participants can benefit from pursuing ways to facilitate more efficient macro risk accounting, improve price and volatility discovery, and expand international risk intermediation activities.

Abstract:
The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy. CCA provides a natural framework for analysis of mismatches between an entity's assets and liabilities, such as currency and maturity mismatches on balance sheets. Policies or actions that reduce these mismatches will help reduce risk and vulnerability. It also provides a new framework for sovereign capital structure analysis. It is useful for assessing vulnerability, policy analysis, risk management, investment analysis, and design of risk control strategies. Both public and private sector participants can benefit from pursuing ways to facilitate more efficient macro risk accounting, improve price and volatility discovery, and expand international risk intermediation activities.

macrofinancial risks, risk propagation, sovereign risk

Abstract:
This paper attempts to draw attention to some important lessons that the Pension Benefit Guaranty Coroporation (PBGC) can learn from the experience of the Federal Savings and Loan Insurance Corporation (FSLIC). FSLIC was the government agency that insured deposits at savings and loan associations until it was replaced in 1989 leaving a massive deficit to be financed by taxpayers. Like FSLIC, the PBGC is a government agency that guarantees a form of private corporate debt. As guarantor of the pension benefits promised by private plan sponsors, the PBGC bears the risk of a shortfall between the value of insured benefits and the assets securing those benefits.

The magnitude of the the PBGC's exposure to shortfall risk depends on three factors:

- the financial strength of plan sponsors,

- the degree of underfunding of insured benefits,

- the mismatch between the market-risk exposure of insured benefits and the assets securing them.

Only the first two of these have been addressed by past legistlative reforms. The third factor appears not to be well understood. It is apparently a widespread belief among policymakers that a well-diversified pension portfolio of equity securities provides an effective long-run hedge against liabilities of defined-benefit pension plans, so that there is no mismatch problem. This belief is mistaken. The policy based upon it creates the potential for large shortfall losses to the PBGC. Therein lies an uncomfortable parallel with the S&L debacle of the 1980s.

PBGC, pension guarantees

Abstract:
The Pension Benefit Guaranty Corporation (PBGC) can learn from the experience of the Federal Savings and Loan Insurance Corporation (FSLIC). As was the case with FSLIC, the mismatch between the market-risk exposure of the corporate liabilities the PBGC insures and the assets backing them creates the potential for large shortfall losses. It is apparently a widespread belief among policy makers that a well-diversified pension portfolio of equity securities provides an effective long-run hedge against liabilities of defined-benefit pension plans, so that there is no mismatch problem. This belief is mistaken. When a pension plan sponsor invests the pension assets in equities, the actuarial present value cost to the PBGC of providing insurance against a shortfall increases rather than decreases with the length of the time horizon, even for plans that currently are fully funded.

Abstract:
Finance is a branch of economics that deals with budgeting, saving, investing, borrowing, lending, insuring, diversifying, and matching. In setting standards of financial literacy we ought to make sure they are consistent with the basic principles taught in economics courses.

financial literacy, financial education, financial literacy standards

Abstract:
This paper explores the application of contingent claims analysis (CCA) to two "hot" issues in life-cycle finance: (1) investing for retirement and (2) deciding when, if ever, to switch careers. Participants in individual retirement accounts do not have the time or the knowledge to make their own investment decisions. Today they are defaulted into life-cycle mutual funds that pass all risk directly through to the participant. We use CCA to demonstrate how financial firms can design and produce guaranteed contingent benefit contracts that improve participant welfare at no additional cost to the system. In exploring the career-choice issue in the second part of the paper, we use CCA in a somewhat different way. The decision to switch careers is analogous to deciding when to exercise an American-style option to swap one asset for another. By applying the methods used to analyze the option-exercise decision to the career-switching problem, we gain some new insights beyond those derived from the traditional dynamic programming approaches.

contingent claims analysis, life-cycle finance, retirement saving plans

Abstract:
This paper explores how to structure choices for personal investment accounts that have a well-defined set of target dates. Key examples are investing for retirement or for a child's college education. We show that if the investor's objective is to minimize the ex ante cost of hitting specific targets at specific dates, the optimal portfolio strategy is to match the portfolio's payoffs to the time profile of those targets and not take any risk. Therefore to accommodate risk-averse investors with diverse time horizons, financial institutions ought to provide their clients with a term structure of risk-free investments to serve as clear points of reference.

In structuring choices with different degrees of risk and reward, an important set of reference points is a term structure of exchange-traded index options and the corresponding set of implied volatilities. In framing the time dimension in this fashion, one avoids the need for explicit forecasts of the term structure of equity risk premia, which are notoriously difficult to forecast. Our approach is not vulnerable to the potential biases inherent in the use of historical time series, such as survivorship bias.

Our approach and the mean-variance efficient frontier approach should be seen as complements rather than as substitutes. We view ours as a natural first step in structuring the time dimension of investment choice in personal investment accounts. Subsequent steps should include econometric modeling and some kind of tailoring to the preferences and circumstances of the end user.

matching, efficient diversification, term structure, implied volatility

Abstract:
This article reviews recent scientific literature on consumer financial decisions over the life cycle outlining its implications for the design of pension plans. It begins with a review of advances in the theory of rational financial planning and wealth management. It then summarizes the recent empirical literature on the actual behavior of households regarding saving, investing, and insuring their consumption in old age. Finally, it briefly comments on the practical implications of the theory for the design of pension systems and outlines areas of future research.

Life cycle finance, portfolio choice, pension, consumption, leisure

Abstract:
This paper explores the application of contingent claims analysis (CCA) to two "hot" issues in life-cycle finance: (1) investing for retirement and (2) deciding when, if ever, to switch careers. Participants in individual retirement accounts do not have the time or the knowledge to make their own investment decisions. Today they are defaulted into life-cycle mutual funds that pass all risk directly through to the participant. We use CCA to demonstrate how financial firms can design and produce guaranteed contingent benefit contracts that improve participant welfare at no additional cost to the system. In exploring the career-choice issue in the second part of the paper, we use CCA in a somewhat different way. The decision to switch careers is analogous to deciding when to exercise an American-style option to swap one asset for another. By applying the methods used to analyze the option-exercise decision to the career-switching problem, we gain some new insights beyond those derived from the traditional dynamic programming approaches.

Contingent claims, job-switching, life-cycle, Arrow-Debreu securities

Abstract:
In September 1997, the U.S. Treasury developed the TIPS market in order to achieve three important policy objectives: 1) to provide consumers with a class of assets that allows for hedging against real interest rate risk; 2) to provide holders of nominal contracts a means of hedging against inflation risk; and 3) to provide everyone with a reliable indicator of the term structure of expected inflation. This paper evaluates the achievement of these objectives and analyzes prospective ways to better meet these objectives in the future, by, for example, extending the maturity of TIPS and/or the use of inflation indexes catered to particular geographic regions or demographics. We conclude by arguing that while it is tempting to consider completing markets by introducing more TIPS-like securities indexed to inflation rates that are more tailored to particular demographics, our analysis suggests that TIPS indexed to CPI do in fact facilitate good synthetic hedges against unexpected changes in inflation for many different investors, since the various inflation measure are very highly correlated. We do however argue for extending the maturity of TIPS.

TIPS, assets, inflation, risk, CPI

Abstract:
Defined Benefit and Defined Contribution plans have significantly different characteristics with respect to the risks faced by employers and employees, the sensitivity of benefits to inflation, the flexibility of funding, and the importance of governmental supervision. In this paper, we examine some of the main tradeoffs involved in the choice between DB and DC plans. Our most general conclusion is that neither plan type can be said to wholly dominate the other from the perspective of employee welfare.The major advantage of DB plans is the potential they offer to provide a stable replacement rate of final income to workers. If the replacement rate is the relevant variable for worker retirement utility, then DB plans offer some degree of insurance against real wage risk. Of course, protection offered to workers is risk borne by the firm. As real wages change, funding rates must correspondingly adjust. However, to the extent that real wage risk is largely diversifiable to employers, and nondiversifiable to employees, the replacement rate stability should be viewed as an advantage of DB plans. The advantages of DC plans are most apparent during periods of inflation uncertainty. These are: the predictability of the value of pension wealth, the ability to invest in inflation-hedged portfolios rather than nominal DB annuities,and the fully-funded nature of the DC plan. Finally, the DC plan has the advantage that workers can more easily determine the true present value of the pension benefit they earn in any year, although they may have more incertainty about future pension-benefit flows at retirement. Measuring the present value of accruing defined benefits is difficult at best and imposes severe informational requirements on workers. Such difficulties could lead workers to misvalue their total compensation, and result in misinformed behavior.

Abstract:
No abstract is available for this paper.

Abstract:
The purpose of this paper is to survey what is known about the investment policy of pension funds. Pension fund investment policy depends critically on the type of plan: defined contribution versus defined benefit. For defined contribution plans investment policy is not much different than it is for an individual deciding how to invest the money in an Individual Retirement Account (IRA). The guiding principle is efficient diversification, that is, achieving the maximum expected return for any given level of risk exposure. The special feature is the fact that investment earnings are not taxed as long as the money is held in the pension fund. This consideration should cause the investor to tilt the asset mix of the pension fund towards the least tax-advantaged securities such as corporate bonds.

For defined benefit plans the practitioner literature seems to advocate immunization strategies to hedge benefits owed to retired employees and portfolio insurance strategies to hedge benefits accruing the active employees. Academic research into the theory of optimal funding and asset allocation rules for corporate defined benefit plans concludes that if their objective is shareholder wealth maximization then these plans should pursue extreme policies. For healthy plans, the optimum is full funding and investment in the riskiest assets. Empirical research so far has failed to decisively confirm or reject the predictions of this theory of corporate pension policy.

Recent rule changes adopted by the Financial Accounting Standards Board regarding corporate reporting of defined benefit plan assets and liabilities may lead to a significant shift into fixed-income securities. The recent introduction of price-level-indexed securities in U.S. financial markets may lead to significant change in pension fund asset allocation. By giving plan sponsors a simple way to hedge inflation risk, these securities make it possible to offer plan participants inflation protection both before and after retirement.

Abstract:
The recent introduction of CPI-linked bonds by several financial institutions is a milestone in the history of the U.S. financial system. It has potentially far-reaching effects on individual and institutional asset allocation decisions because these securities represent the only true long-run hedge against inflation risk.

CPI-linked bonds make possible the creation of additional financial innovations that would use them as the asset base. One such innovation that seems likely is inflation-protected retirement annuities. The introduction of index-linked bonds eliminates one of the main obstacles to the indexation of benefits in private pension plans. A firm could hedge the risk associated with a long-term indexed liability by investing in index-linked bonds with the same duration as the indexed liabilities.

Abstract:
This paper proposes a new approach to improve the way central banks can analyze and manage the financial risks of a national economy. It is based on the modern theory and practice of contingent claims analysis (CCA), which is successfully used today at the level of individual banks by managers, investors, and regulators. The basic analytical tool is the risk-adjusted balance sheet, which shows the sensitivity of the enterprise's assets and liabilities to external shocks. At the national level, the sectors of an economy are viewed as interconnected portfolios of assets, liabilities, and guarantees - some explicit and others implicit. Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis. The CCA approach is well-suited to capturing such non-linearities and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.

Abstract:
No abstract is available for this paper.

Abstract:
Guarantees of financial contracts, such as loans, deposit insurance, and swaps, pervade the financial system and play an important role in corporate and public finance. This paper develops a framework for analyzing the efficient management of such guarantees in both the private and public sectors. Within the private sector, it explores applications of guarantee management in non-financial corporations as well as financial institutions. Just as there are special advantages to having government rather than private entities provide guarantees, so there are special problems. The paper identifies these advantages and problems and explores some of the tradeoffs between government and private-sector solutions to the guarantee problem. A central point is that the principles for effective management of guarantees are the same, whether in the corporate, financial, or public sectors.

Abstract:
This paper contrasts and empirically tests two different views of corporate pension policy: the traditional view that pension funds are managed without regard to either corporate financial policy or the interests of the corporation and its shareholders, and the corporate financial perspective represented by the recent theoretical work of Black (1980), Sharpe (1916), Tepper (1981), and Treynor (1971), which stresses the potential effects of a firm's financial condition on its pension funding and asset allocation decisions. We find several pieces of evidence supporting the corporate financial perspective. First, we find that there is a significant inverse relationship between firms' profitability and the discount rates they choose to report their pension liabilities. In view of this we adjust all reported pension liabilities to a common discount rate assumption. We then find a significant positive relationship between firm profitability and the degree of pension funding, as is consistent with the corporate financial perspective. We also find some evidence that firms facing higher risk and lower tax liabilities are less inclined to fully fund their pension plans. On the asset allocation question, we find that the distribution of plan assets invested in bonds is bi-modal, but that it does not tend to cluster around extreme portfolio configurations to the extent predicted by the corporate financial perspective. We also find that the percentage of plan assets invested in bonds in negatively related to both total size of plan and the proportion of unfunded liabilities. The latter relationship shows up particularly among the riskiest firms and is consistent with the corporate financial perspective on pension decisions.

Abstract:
No abstract is available for this paper.

Abstract:
This paper explores both theoretically and enirically the role of nominalbonds of various maturities in investor portfolios in the U.S. One of its principal goals is to determine whether an investor who is constrained to limithis investment in bonds to a single portfolio of money-fixed debt instruments will suffer a serious welfare loss. Our interest in this question stemsi n part from the observation that many employer-sponsored savings plans limit a participant`s investment choices to two types, a common stock fund and a money-fixed bond fund of a particular maturity. A second goal is to study the desirability and feasibility of introducing a market for index bonds (i.e. an asset offering a riskless real rate of return) in the U.S. capital markets.The theoretical framework is Merton`s (1971) continuous time model of consumption and portfolio choice. Our measure of the welfare gain or loss from a given change in the investor`s opportunity set is the increment to current wealth needed to completely offset the effect of the change. A novel feature of our empirical approach is the method of deriving equilibrium risk premia on the various asset classes. We employ the variance-covariance matrix of real rates of return estimated from historical data in combination with "reasonable" assumptions about net asset supplies and the economy-wide average degree of risk aversion to derive numerical values for these risk premia. This procedure allows us to circumvent the formidable estimation problems associated with using historical means, which are negative during some subperiods.Our main results are: (i) There can be a substantial loss in welfare for participants in savings plans offering a choice of only two funds, a diversified stock fund and an intermediate-term bond fund. Most of this loss can be eliminated by introducing as a third option a money market fund.(2) The potential welfare gain from the introduction of private index bonds in the U.S.capital market is probably not large enough to justify the costs of innovation.The major reason for the small gain is that one month bills with their small variance of real returns are an effective substitute for index bonds.

Abstract:
No abstract is available for this paper.

Abstract:
A contract to insure $1 against inflation is equivalent to a European call option on the consumer price index. When there is no deductible this call option is equivalent to a forward contract on the CPI. Its price is the difference between the prices of a zero coupon real bond and a zero coupon nominal bond, both free of default risk. Provided that the risk-free real rate of interest is positive, the price of such an inflation insurance policy first rises and then falls with time to maturity. It is a decreasing function of the real interest rate and an increasing function of both the expected rate of inflation and the real risk premium on nominal bonds. When a deductible is introduced, the insurance policy can no longer be priced like a CPI forward contract. The option feature has its greatest value when the deductible is close to the forward rate of inflation, defined as the difference between the risk-free nominal and real interest rates. Such inflation insurance contracts are priced using the model developed by Black-Merton-Scholes. Pricing an inflation insurance policy with a cap requires only a minor modification of the model. The approach presented in this paper permits fairly precise quantification of the cost of implementing proposals to index pension benefits for inflation. It also gives us a way of estimating the savings to the Social Security system that would result from introducing a deductible. Key words: Inflation, insurance, forward contract, call option, put option, contingent claim, deductible, cap, futures contract, CPI, dynamic hedging, portfolio rebalancing.

Abstract:
This paper develops a model showing that people who have flexibility in choosing how much to work will prefer to invest substantially more of their money in risky assets than if they had no such flexibility. Viewed in this way, labor supply flexibilty offers insurance against adverse investment outcomes. The model provides support for the conventional wisdom that the young can tolerate more risk in their investment portfolios than the old. The model has other implications for the study of household financial behavior over the life cycle. It implies that households will take account of the value of labor supply flexibility in deciding how much to invest in their own human capital and when to retire. At the macro level it implies that people will have a labor supply response to shocks in the financial markets.

Abstract:
No abstract is available for this paper.

Abstract:
This paper is organized as follows: The first part of the paper introduces the topic. In the next part, we explore the inadequacies of conventional and equity-based variable annuities in an inflationary environment by contrasting them with a hypothetical PPA. We then try to assess the suitability of money market instruments hedged with commodity futures as the asset base for PPA's, and consider the possibility of having financial institutions offer them to the public. The major conclusion of the paper is that private pension plans could offer retiring employees a choice between a conventional money-fixed annuity or a PPA, both of which would cost theemployer the same amount of money to fund, although this option would require the PPA benefitlevel in the first few years of retirement to be lower than that of the conventional annuity.

Abstract:
No abstract is available for this paper.

Abstract:
This paper applies the Capital Asset Pricing Model to help explain the anomalous behavior of real interest rates during the last several years. Specifically,we are able to show that the increased volatility of bond prices since the change in Federal Reserve operating procedure in October 1979 has substantially increased the required real risk premium on long term bonds. We also consider and reject the possibility that increased risk alone accounts for the recent increase in the short-term real rate. Finally, we use the model to simulate the financial effects of a Federal debt maturity management operation.

Abstract:
This paper examines the tilt and risk-return characteristics of real retirement incomes provided by variable annuities tied to bills, long-term bonds, stocks and a mixed portfolio which combines all three. The analysis emphasizes the riskiness of the real value of benefits provided by conventional nominal annuities. The Rockefeller Foundation Plan, together with the "ad hoc" cost-of-living adjustments made by many large firms, are interpreted as representative market responses to increased inflation uncertainty. The paper examines the annuity designs implicit in these innovations, and shows them to be variants of the standard variable annuity.

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Abstract:
No abstract is available for this paper.

Abstract:
The aim of this paper is to explore a new type of pension plan tailored to the needs and preferences of individuals living in Europe. The personal pension accounts that we propose are semi-tailored contracts that are rational when judged from the perspective of normative economic theory. Such contracts can be designed and marketed through an employer, a trade union, or other trusted institution so as to minimize agency costs and take advantage of scale economies. Moreover, they can be offered as optimal defaults to groups of plan members with similar characteristics. There is much that governments can do at very low cost to facilitate the efficient production of these contracts.

pensions, behavioral economics, guarantees

Abstract:
This paper proposes a new approach to measure, analyze, and manage sovereign risk based on the theory and practice of modern contingent claims analysis (CCA). The paper provides a new framework for adapting the CCA model to the sovereign balance sheet in a way that can help forecast credit spreads and evaluate the impact of market risks and risks transferred rom other sectors. This new framework is useful for assessing vulnerability, policy analysis, sovereign credit risk analysis, and design of sovereign risk mitigation and control strategies. Applications for investors in three areas are discussed. First, CCA provides a new framework for valuing, investing, and trading sovereign securities, including sovereign capital structure arbitrage. Second, it provides a new framework for analysis and management of sovereign wealth funds being created by many emerging market and resource rich countries. Third, the framework provides quantitative measures of sovereign risk exposures which facilitates the design of new instruments and contracts to control or transfer sovereign risk.

Contingent claims analysis, sovereignrisk, Merton Model, capital structure arbitrage

Abstract:
Target-date funds (TDFs) for retirement, also known as life-cycle funds, are being offered as a simple solution to the investment task of participants in self-directed retirement plans. A TDF is a "fund of funds" diversified across stocks, bonds, and cash with the feature that the proportion invested in stocks is automatically reduced as time passes. Empirical evidence suggests that a simple TDF strategy would be an improvement over the choices currently made by many uninformed plan participants. This article explores a way to achieve even greater improvement for people who are very risk averse and have high exposure to market risk through their labor.

Private Wealth Management, Asset Allocation, Investment Policy Formulation, Portfolio Management, Asset Allocation

Abstract:
This paper proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities. It is a synthesis of the neoclassical, neo-institutional, and behavioral perspectives. Neoclassical theory is an ideal driver to link science and global practice in finance because its prescriptions are robust across time and geopolitical borders. By itself, however, neoclassical theory provides little prescription or prediction of the institutional structure of financial systems - that is, the specific kinds of financial intermediaries, markets, and regulatory bodies that will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms. The neoclassical model therefore offers important, but incomplete, guidance to decision makers seeking to understand and manage the process of institutional change. In accomplishing this task, the neo-institutional and behavioral perspectives can be very useful. In this proposed synthesis of the three approaches, functional and structural finance (FSF), institutional structure is endogenous. When particular transaction costs or behavioral patterns produce large departures from the predictions of the ideal frictionless neoclassical equilibrium for a given institutional structure, new institutions tend to develop that partially offset the resulting inefficiencies. In the longer run, after institutional structures have had time to fully develop, the predictions of the neoclassical model will be approximately valid for asset prices and resource allocations. Through a series of examples, the paper sets out the reasoning behind the FSF synthesis and illustrates its application.

Financial system, financial structure, risk management

Abstract:
An important function of the financial system is to serve as a key source of information that helps coordinate decentralized decision-making in various sectors of the economy. Households and investors use interest rates, futures prices and security prices in making their consumption-saving decisions and portfolio allocation decisions. Interest rates and prices provide important signals to managers of firms in their selection of investment projects and financings.This paper illustrates the role played by financial markets in providing information about the future volatility-that is, the degree of uncertainty-of economic variables such as interest rates, exchange rates, commodity prices, and stock, bond and other security prices. It has two basic goals: (1) to show the importance of volatility for all sorts of policy decisions in the private and public sectors of the economy; and (2) to show how ex ante estimates of future volatility can be extracted from the prices of securities.

Abstract:
This paper develops a conceptual framework for analyzing the global financial system. The framework has two major objectives: to address differences in institutional structure across borders and to explain changes in these institutional structures over time. Applicability of the framework ranges widely, from analysis of the entire financial system to individual business strategy decisions and specific public policy choices. It rests on two basic premises:

-Financial functions are more stable than financial institutions-that is, functions vary less across borders and change less over time.

-Competition will cause evolution in institutional structures to produce greater efficiency in the performance of financial system functions. That is, institutional form follows its function.

The evolution of the financial system is portrayed as an innovation spiral in which organized markets and intermediaries compete with each other in a static sense and complement each other in a dynamic sense.

Abstract:
This paper considers the changes in financial infrastructure and regulation necessary to support welfare-improving financial innovation. Topics discussed include the development of a system of risk accounting, the regulation of OTC derivatives, reform of deposit insurance, pension reform and privatization, and the use of financial technology in implementing macro-stabilization policies.