Welcome to the Public Interest Paper section. Here we store shorter papers written for expository reasons or to encourage policy debate. Longer and more technical papers can be found on the Technical Papers page.

The bonus pool, mark to market and free cash flow   Proposals from G20 or national regulators that seek to limit or govern bonuses in the banking finance industry in the interests of systemic stability need to be grounded in the financial economics of producer surplus and its distribution. In this respect, existing treatments of economic agency in justifying large bonus awards are content to accept accounting P&L numbers as a basis for the managerial bonus pool. We argue that managerial bonuses and shareholder dividends should be treated more symmetrically, and constrained by free cash flow criteria that capture producer surplus created by genuine managerial ability. Priority rules should apply, such that fair market value is a compensation for shareholder risk bearing and not a source of managerial surplus. The use of free cash flow conversion ratios neutralises the free option problem that has become a social irritant in public bailouts.   Click Here To Download

Credit securitisation, information, and system stability   The leveraging of credit that precipitated the subprime crisis was vectored via a proliferation of investment vehicles and credit derivatives, driven in part by competitive pressures to enhance returns by economising on economic capital. Theoretically, this should have spread risk and improved economic efficiency, but in practice it exposed the system to a meltdown. Critical points for system stability are the certification of credit equivalence required by decentralised information trading, and the portfolio equivalence of credit default swaps and the physical loan book. Regulatory implications encompass the trade off between collateral and economic capital in liability recognition for credit default swaps; enhanced tests for fiduciary duty; managerial reward regimes; and periodic regulator advisories as to state dependence of credit ratings.   Click Here To Download

The subprime crisis and the economic fallout   The subprime crisis, as it was called in early 2007, has blown up into a global credit crunch. The economic fallout has converted what might otherwise have been a more or less routine recession into the prospect of something much worse: a full scale economic depression. Governments round the world are following a convergent policy path to try to stave off the prospect. It is dominated by good old fashioned Keynesian deficit financing and in some cases bad old fashioned money printing; involving financial bailouts or guarantees, and likewise some mega scale fiscal rescues. This public interest paper takes the form of a set of slides prepared for public lectures by Roger Bowden, and updated to early March 2009. They outline in non technical terms the causal influences and sequences, the current state, policy choices, and future prospect for the financial and economic system.   Click Here To Download

The NZ term structure: Going long in infrastructure   The NZ term structure of interest rates is long in liquidity at the short end of maturities, but entirely absent at the long end. This entails market completion and other welfare problems, notably in encouraging long term saving, retirement income support, tax non-neutralities, public sector funding, insurance support, and other exigencies. A possible issuance role for a sovereign infrastructure fund is mooted in connection with long term debt issues to support infrastructure funding. Equity in the special investment vehicle (ISFV) or fund takes the form of preference shares. The IFSV invests in primary debt securities written by state or local government to fund IFS projects and repackages these into asset backed securities issued to the public. The proposed generic structure facilitates the funding of cooperative IFS ventures involving central and local government together with private equity partnerships and can be adapted to a trans-Tasman facility. Synergistic enhancements include lifecycle derivatives and retirement funding.   Click Here To Download

Monetary policy and the exchange rate: The Kiwi that had to fly   June 2007 saw the first serious attempt by the Reserve Bank of New Zealand to exercise its currency intervention powers, in an attempt to put a cap on the soaring NZ dollar. Sceptics pointed out that this was inconsistent with the comfort to the foreign exchange carry trade conveyed by signals that the official cash rate would remain high or even tightened further, and intervention attempts could even perversely drive the currency higher. The problem for monetary policy has been that in an incomplete debt market, the only real channel for the official cash rate to impact on fixed rate home mortgage rates is via the indirect feedback from offshore NZ interest rates. This means that the exchange rate becomes the vector. We argue on the basis of forward interest rates that the problem is fixing itself, and from here on will only be hindered by currency intervention or further tightening signals from the central bank.   Click Here To Download

Instrument insufficiency and economic stabilisation   Recently concerns have been raised in New Zealand about the effectiveness of monetary policy in controlling inflation while avoiding damage to the economy from high exchange rates. This review examines the basis for concern and identifies the problem as a failure in the primary instrument, namely the Reserve Bank’s official cash rate, to adequately impact further along the term structure curve, which has become the more sensitive area for aggregate demand. Direct control over expenditure is therefore weak, and too much leeway is left to the housing and other asset markets to sustain demand in the economy. Globalisation of credit availability and financial technology have helped to blunt the policy instrument in this respect, shifting the adjustment burden on to the exchange rate. Deft management of interest and currency expectations can help, but the problem may require closer coordination and cooperation between monetary and fiscal policy, restoring a stabilisation role for the latter.   Click Here To Download

Which are the world’s wobblier currencies?   Measuring country exchange rates relative to a common reference basket results in a set of no-arbitrage prices, unlike trade-weighted indexes, the usual method of comparing country exchange rate histories. The reference basket is analogous to a portfolio, and its choice can be resolved by drawing on required economic interpretations or uses. We use currency reference rates to examine the historical variability of different currencies over designated cyclical bands. The temporal decompositions used are those provided by wavelet analysis, which is light on maintained assumptions about data generating processes. Some countries, notably Japan and New Zealand, exhibit a powerful but irregular medium term cycle, while others are much more stable. Implications are briefly examined for investment, hedging, monetary policy and common currency studies.   Click Here To Download

The agribusiness cycle and its wavelets   Cyclical exposures of farm profit to the economic environment are a fact of life for farmers. By utilising the farmer terms of trade as a net profit margin metric, we show how wavelet analysis can be used to decompose the cycle and trend, analyse causal influences, and detect structural breaks. With the NZ dairy industry as case study, the wavelet decomposition reveals that shorter cycles are almost wholly the result of commodity prices. Longer cycles are produced by the interaction of commodity prices with the exchange rate, but with a strong natural buffering element. The buffer was upset following the Asian crisis of 1997-8, but may have restored itself since. A favourable long-term trend has appeared from the mid nineties onwards. Implications for risk management are briefly examined.   Click Here To Download

An overview of ordered mean difference portfolio technology   The ordered mean difference construction provides a metric for investor surplus in the form of a simple spreadsheet construction relating the returns on a designated security or portfolio to those on a given benchmark. The metric itself is well grounded in utility theory, and represents alternative attitudes towards risk in the form of risk profiling against a range of possible investor preferences. This paper reviews the basis of the construction in non technical terms and shows how it can be applied to a range of problems in portfolio practice and related investment or risk management situations. These cover performance measurement, mispricing and anomalies, CAPM testing, risk profiling, portfolio enhancement, hedging, portfolio choice algorithms, and stochastic dominance. Discussion is illustrated with examples drawn from recent research papers in the area.   Click Here To Download