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April 1999

Research
U P D AT E
f r o m t h e F e d e r a l R e s e r v e B a n k o f N e w Yo r k
RESEARCH AND MARKET ANALYSIS GROUP

Staff Reports Series Goes Electronic
The Research and Market Analysis Group will
now be making all new issues of Staff Reports
available through its Internet site (www.ny.
frb.org/rmaghome/staff_rp/1999.htm). From
the site, interested readers can download the
latest papers and many earlier issues in Adobe
Acrobat format.
With the shift to full electronic presentation, we will no longer be distributing hard
copies of individual papers in the Staff

Reports series. Each issue of Research Update,
however, will carry brief summaries of new
papers. In addition, we encourage readers to
subscribe to our free Electronic Alert Service.
As a subscriber to the service, you will receive
e-mail listings of RMAG’s latest Staff Reports
and other publications. You can sign up for
Electronic Alert quickly and easily by visiting
www.ny.frb.org/rmaghome.

“Decay” Rate of Supervisory Information Supports FDICIA’s
Bank Exam Frequency Standards
Supervisory agencies consider bank examinations a timely and reliable source of information about an institution’s financial condition
and risk profile. This private information,
however, is costly to acquire because it can be
gathered only during the on-site exams.
Therefore, it is important for supervisors and
banks to know how quickly private information
“decays,” or loses its value.

In “Supervisory Information and the
Frequency of Bank Examinations” (Economic
Policy Review, vol. 5, no. 1), Beverly Hirtle and
Jose Lopez evaluate how the length of time
between bank exams affects the quality of
information available to supervisors. To that
end, the authors assess the amount of time it
takes for private supervisory information to
decay. The faster the information loses its

Ne w Research: Januar y–March 1999

value, they observe, the more frequently
exams need to occur for supervisory agencies
to have accurate information about the current condition of banks. Since 1991, the
Federal Deposit Insurance Corporation
Improvement Act (FDICIA) has mandated
annual on-site exams for most U.S. commercial banks.
Hirtle and Lopez’s analysis suggests that
the information decay rate is fairly rapid.
They find that private supervisory information fails to provide a useful picture of a

bank’s current condition after only six to
twelve quarters. Moreover, the decay rate
appears to be faster in years when the banking industry experiences financial difficulties, and the rate is significantly faster for
troubled banks than for healthy ones. From
this evidence, the authors conclude that
FDICIA’s requirement for annual bank
exams is reasonable, particularly for banks
whose initial financial condition is troubled
or during times of financial stress for the
banking industry.

Publications and Papers
The Research and Market Analysis Group produces a wide range of publications and
discussion papers:
• The Economic Policy Review—a policy-oriented research journal focusing on
macroeconomic, banking, and financial market topics.
www.ny.frb.org/rmaghome/econ_pol/1999.htm
• Current Issues in Economics and Finance—a newsletter-style publication offering
concise and timely analyses of economic and financial topics.
www.ny.frb.org/rmaghome/curr_iss/1999.htm
• Second District Highlights—a regional supplement to Current Issues covering financial
and economic developments in the Federal Reserve System’s Second District.
www.ny.frb.org/rmaghome/curr_iss/sec_dis/index.htm
• Staff Reports—technical papers presenting research findings, designed to stimulate
discussion and elicit comments. These papers are intended for publication in leading
economic and finance journals. Staff Reports are available only in electronic form.
www.ny.frb.org/rmaghome/staff_rp/1999.htm
• Publications & Other Research—a brochure spotlighting the Group’s research output for
the year.
www.ny.frb.org/rmaghome/otherres

A New Study Explores the Theory behind Macro Markets
Uncertainty about national income growth
poses significant economic risk to households
all over the world. To help reduce investors’
exposure to this risk, researchers have proposed a controversial new set of security
markets—called macro markets—that would
trade long-term claims on the income of an
entire country or region.
In “Macro Markets and Financial Security”
(Economic Policy Review, vol. 5, no. 1),
Stefano Athanasoulis, Robert Shiller, and Eric
van Wincoop explain the theory behind macro
markets and describe how these markets
would be used by the average investor.
Through macro markets, investors could
buy a claim on a country’s national income
and then receive dividends equal to a fraction
of that income for as long as the claim is held.
By holding offsetting positions in domestic and
foreign markets—going short in the domestic
market and long in foreign markets—investors
could hedge their home-country risk.

To estimate the potential risk-management
benefits of macro markets, Athanasoulis,
Shiller, and van Wincoop calculate the size of
the country-specific risk component of per
capita GDP for a sample of forty-nine countries. The results reveal that country-specific
risk can be significant: after controlling for
expected growth, the authors find that over a
period of thirty-five years the per capita GDP
of the best-performing country is likely to
increase by a factor of five relative to that of
the worst-performing country.
If macro markets could potentially reduce
country-specific risk and create investment
opportunities, why don’t they already exist?
The authors assert that many barriers stand in
the way of market development, including
investors’ focus on short-term portfolio performance, sizable startup costs, and contract
enforcement difficulties.

Japanese Exporters Respond to Fluctuating Yen
by Adjusting Profit Margins
When exchange rates shift, exporters decide
how much to adjust the prices seen by their foreign customers. This decision requires the firms
to make a trade-off between maintaining profit
margins and maintaining stable export sales.
According to Thomas Klitgaard, Japanese
exporters balance these objectives when the
yen fluctuates by changing profit margins significantly in order to moderate the exchange-

rate-induced changes in the prices seen by
their foreign customers (“Exchange Rates and
Profit Margins: The Case of Japanese
Exporters,” Economic Policy Review, vol. 5,
no. 1). Klitgaard’s conclusion is based on his
analysis of Japan’s industrial machinery, electrical machinery, transportation equipment,
and precision equipment industries, which
accounted for 75 percent of the country’s
exports in 1997.

Federal Reser ve Bank of Ne w York

In industrial machinery, electrical
machinery, and transportation equipment,
the author finds that Japanese exporters pass
on somewhat more than half of any change in
the yen to the price seen by their foreign
customers; they absorb the remainder by
adjusting profit margins on foreign sales. He
also finds that the direction of the yen’s
movement has no effect on the exporters’ willingness to use profit margins to stabilize

prices in foreign markets. Klitgaard notes that
since the beginning of the Asian currency crisis
in mid-1997, only exporters in electrical
machinery have changed their pricing
behavior. However, he concludes that these
actions were more likely due to such factors as
the exporters’ uncertainty about the demand
of their foreign and domestic customers than
to changes in how firms respond to the yen.

Recently Published
Paul Bennett. 1999.“Rational Bias in Macroeconomic Forecasts,” with David Laster
and In Sun Geoum. Quarterly Journal of Economics 114, no. 1 (February): 293-318.
Richard Deitz. 1999.“Income Variability, Uncertainty, and Housing Tenure Choice,” with
John Robst and Kim Marie McGoldrick. Regional Science and Urban Economics 29, no. 2
(March): 219-29.
Rebecca S. Demsetz and Philip E. Strahan. 1999.“The Consolidation of the Financial Services
Industry: Causes, Consequences, and Implications for the Future,” with Allen N. Berger.
Journal of Banking and Finance 23, nos. 2-4 (February): 135-94.
Martin Lettau. 1999.“Rules of Thumb versus Dynamic Programming,” with Harald Uhlig.
American Economic Review 89, no. 1 (March): 148-74.
Hamid Mehran. 1998.“CEO Incentive Plans and Corporate Liquidation Policy,” with George E.
Nogler and Kenneth B. Schwartz. Journal of Financial Economics 50, no. 3 (December): 319-49.
Hamid Mehran. 1998.“The Effect of Changes in Ownership Structure on Performance: Evidence
from the Thrift Industry,” with Rebel A. Cole. Journal of Financial Economics 50, no. 3
(December): 291-318.
Paolo Pesenti and Cédric Tille. 1999.“Competitive Devaluations: A Welfare-Based Approach,”
with Giancarlo Corsetti and Nouriel Roubini. NBER Working Paper no. 6889 (January).
Simon M. Potter. 1999.“Bayes Factors and Nonlinearity: Evidence from Economic Time Series,”
with Gary Koop. Journal of Econometrics 88, no. 1 (February): 251-81.
Eric van Wincoop. 1999.“How Big Are Potential Welfare Gains from International Risksharing?”
Journal of International Economics 47, no. 1 (February): 109-35.

Mortgage Rate Concentration Prompts Surge in Refinancing
Mortgage refinancings skyrocketed to record
levels last year in response to modest interest
rate declines. In “Mortgage Refinancing and
the Concentration of Mortgage Coupons,”
Paul Bennett, Frank Keane, and Patricia
Mosser (Current Issues, vol. 5, no. 4) attribute
the strength of this reaction to the high concentration of mortgage loans that quite suddenly became cost effective to refinance.
The authors explain that for several years
after 1993, new loans were originated at interest rates between 7 and 9 percent, resulting in
a dense concentration of coupon rates. By the
end of 1997, roughly 83 percent of mortgage
loans fell in the 7.25 to 8.75 percent range.
As market rates on new thirty-year fixed rate
loans dropped toward 7 percent in January
1998, the spread between the market rates and
rates on many of these existing mortgages
widened to the point where refinancing
became economically advantageous. As a
result, an unusually large number of homeowners chose to refinance. When rates edged

down again in the second half of 1998, more
loans in the 7 to 9 percent range crossed the
refinancing threshold, prompting refinancing
applications to rise to even higher levels.
To test the importance of rate concentration
in explaining refinancings, the authors construct a series of statistical models. The model
results indicate that the interest rate spread
and the distribution of rates on existing mortgages together explain a sizable 77 percent of
refinancings between 1990 and 1998.
The models also suggest that low unemployment—a sign of a robust economy—contributed to the sharp increase in refinancings in
1998. Strong employment very likely helped
build borrower creditworthiness and lender
confidence, enabling more borrowers to refinance. Finally, the high proportion of outstanding mortgages between two and five years
old may have played a role in the refinancing
surge. These “moderately seasoned” loans are
statistically more likely to be refinanced than
new or fully seasoned loans.

New Titles in the Staff Reports Series
The following new Staff Reports are available electronically at the Research and Market Analysis
Group’s web site: www.ny.frb.org/rmaghome/staff_rp/1999.htm.

Macroeconomics and Growth
Are Apparent Findings of Nonlinearity Due
to Structural Instability in Economic Time
Series? by Gary Koop and Simon M. Potter
(Number 59)

Many modeling issues and policy debates in
macroeconomics depend on whether macroeconomic
time series are best characterized as linear or nonlinear.
Koop and Potter’s empirical exercise using several
macroeconomic time series shows that findings of
threshold-type nonlinearities could be due to structural instability.

Nonlinear Risk, by Marcelle Chauvet
and Simon M. Potter (Number 61)

Chauvet and Potter propose a flexible framework for
analyzing the joint time series properties of the level
and volatility of expected excess stock returns. They
find that a distinct business cycle pattern exists in the
conditional expectation and variance of the monthly
value-weighted excess returns.

Federal Reser ve Bank of Ne w York

Nonlinear Impulse Response Functions,
by Simon M. Potter (Number 65)

The standard linear technique of impulse response
function analysis is extended to the nonlinear case by
defining a generalized impulse response function.
Measures of persistence and asymmetry in response are
constructed for a wide class of time series.
Fluctuations in Confidence and Asymmetric
Business Cycles, by Simon M. Potter
(Number 66)

The asymmetries found in postwar U.S. output are
inconsistent with the behavior of the U.S. economy
during the Great Depression. Potter concludes that this
asymmetry can be attributed to a reduction in investor
confidence produced by misguided government intervention during the Depression rather than to the success
of postwar stabilization policy.
Structural Estimates of the U.S. Sacrifice
Ratio, by Stephen G. Cecchetti
and Robert W. Rich (Number 71)

Cecchetti and Rich investigate the statistical properties of the U.S. sacrifice ratio—the cumulative output
loss arising from a permanent reduction in inflation.
They derive estimates of the sacrifice ratio from three
structural VAR models and then conduct Monte Carlo
simulations to analyze their sampling distribution. The
estimates are found to provide a very unreliable guide
for assessing the output cost of a disinflation policy.

International
Competitive Devaluations: A Welfare-Based
Approach, by Giancarlo Corsetti, Paolo Pesenti,
Nouriel Roubini, and Cédric Tille
(Number 58)

The authors use a three-country center-periphery
model to examine the mechanism by which exchange
rate shocks are transmitted across countries. They
provide a choice-theoretic framework for the policy
analysis and empirical assessment of competitive
devaluations.

Exchange Rates and Local Labor Markets,
by Linda Goldberg and Joseph Tracy
(Number 63)

Goldberg and Tracy document the consequences of
real exchange rate movements for the employment,
hours, and hourly earnings of workers in manufacturing industries across states. The importance and size of
these dollar-induced effects are found to vary considerably across industries and to be more pronounced in
some U.S. regions.
The Role of Consumption Substitutability in
the International Transmission of Shocks,
by Cédric Tille (Number 67)

An expansionary shock that would be beneficial in
a closed economy can have an adverse “beggar-thyself ”
effect in the country where it takes place or an adverse
“beggar-thy-neighbor” effect on a neighboring country.
Such effects depend significantly on the degree of substitutability between goods produced in different countries and the exact nature of the shocks.
Determinants of Currency Risk Premiums,
by John A. Carlson and C. L. Osler (Number 70)

A theoretical model of exchange rate determination
suggests that forward premiums are negatively related
to rationally expected future exchange rate changes.
Carlson and Osler provide new empirical evidence
supporting the results of their model.
The Nature and Growth of Vertical
Specialization in World Trade,
by David Hummels, Jun Ishii,
and Kei-Mu Yi (Number 72)

Vertical specialization—the use of imported
inputs in producing goods that are exported—has
become an increasingly important part of world
trade. Estimates show that vertical specialization has
grown approximately 40 percent in the last twentyfive years; today, it accounts for approximately
30 percent of world exports.

Get New Research Quickly
via Electronic Alert
By subscribing to our free Electronic Alert
Service, you can automatically receive
e-mail notifications when new publications

Banks’ Payments-Driven Revenues,
by Lawrence J. Radecki (Number 62)

The amount of fee income earned by the banking
sector suggests that the significance of payments services has been greatly understated. According to
Radecki, payments services account for one-third to
two-fifths of the combined operating revenues of the
largest banks—a finding that establishes these services
as a core activity of commercial banks.

are posted at our web site. You can then
go directly to the site and download the
materials. Please visit the site for details.
www.ny.frb.org/rmaghome

Microeconomics
U.S. Wages in General Equilibrium: The
Effects of Prices, Technology, and Factor
Supplies, 1963-1991, by James Harrigan
and Rita A. Balaban (Number 64)

Why has wage inequality in the United States
increased in the past two decades? By estimating the general equilibrium relationship between prices, factor supplies, and wages and technology, Harrigan and Balaban
find that both relative factor supply and relative price
changes play an important role in explaining the growing
gap in wages between high-skilled and low-skilled workers.

Banking and Finance
Do Investors Mistake a Good Company for a
Good Investment? by Peter Antunovich
and David S. Laster (Number 60)

If investors confused a firm’s quality with its investment attractiveness, would shares of well-run companies be bid up too high and subsequently earn negative
abnormal returns? The authors determine that the
opposite is true: The magnitude of the abnormal returns
for admired firms and the returns’ persistence over five
years suggest that these firms are not overpriced.

Looking beyond the CEO: Executive
Compensation at Banks, by Rebecca S. Demsetz
and Marc R. Saidenberg (Number 68)

The literature on executive compensation at banks
has generally assumed that a single elasticity can
adequately describe the sensitivity of executive pay to
performance. Demsetz and Saidenberg challenge this
assumption and find that the structure of compensation,
and to some extent the sensitivity of pay to performance,
vary across firms of different sizes and across executives with different responsibilities.
Bank Loan Sales: A New Look at the
Motivations for Secondary Market Activity,
by Rebecca S. Demsetz (Number 69)

This paper clarifies the benefits of an active secondary market that allows banks to transfer loans from
their own books to the books of other institutions. In
addition, the paper offers predictions about the future of
this secondary market in a world of rapid consolidation
and disappearing barriers to geographical expansion.
Liquidity in U.S. Fixed Income Markets:
A Comparison of the Bid-Ask Spread in
Corporate, Government, and Municipal
Bond Markets, by Sugato Chakravarty
and Asani Sarkar (Number 73)

Using newly available transactions data,
Chakravarty and Sarkar examine the determinants of
the realized bid-ask spread in the U.S. corporate, municipal, and government bond markets for the years 1995-97.
They find that liquidity is an important determinant of
the realized bid-ask spread in all three markets.

Federal Reser ve Bank of Ne w York

RESEARCH AND MARKET ANALYSIS GROUP
PUBLICATIONS AND PAPERS:
JANUARY–MARCH 1999
Economic Policy Review
Volume 5, Number 1
Supervisory Information and the Frequency of Bank
Examinations, by Beverly J. Hirtle and Jose A. Lopez
Macro Markets and Financial Security, by Stefano
Athanasoulis, Robert Shiller, and Eric van Wincoop
Exchange Rates and Profit Margins: The Case of
Japanese Exporters, by Thomas Klitgaard

Current Issues in Economics
and Finance
Paying Electronic Bills Electronically,
by Lawrence J. Radecki and John Wenninger
Volume 5, Number 1 (January)
Second District House Prices: Why So Weak in the
1990s? by Matthew Higgins, Carol Osler,
and Anjali Sridhar
Volume 5, Number 2 (January)
Second District Highlights
Meet the New Borrowers, by Sandra E. Black
and Donald P. Morgan
Volume 5, Number 3 (February)
Mortgage Refinancing and the Concentration of
Mortgage Coupons, by Paul Bennett, Frank Keane,
and Patricia C. Mosser
Volume 5, Number 4 (March)

Staff Reports
Available electronically at www.ny.frb.org/
rmaghome/staff_rp/1999.htm.
Competitive Devaluations: A Welfare-Based
Approach, by Giancarlo Corsetti, Paolo Pesenti,
Nouriel Roubini, and Cédric Tille
Number 58 (January)
Are Apparent Findings of Nonlinearity Due to
Structural Instability in Economic Time Series?
by Gary Koop and Simon M. Potter
Number 59 (January)
Do Investors Mistake a Good Company
for a Good Investment? by Peter Antunovich
and David S. Laster
Number 60 (January)

Nonlinear Risk, by Marcelle Chauvet
and Simon M. Potter
Number 61 (February)
Banks’ Payments-Driven Revenues,
by Lawrence J. Radecki
Number 62 (February)
Exchange Rates and Local Labor Markets,
by Linda Goldberg and Joseph Tracy
Number 63 (February)
U.S. Wages in General Equilibrium: The Effects of
Prices, Technology, and Factor Supplies, 1963-1991,
by James Harrigan and Rita A. Balaban
Number 64 (February)
Nonlinear Impulse Response Functions,
by Simon M. Potter
Number 65 (February)
Fluctuations in Confidence and Asymmetric
Business Cycles, by Simon M. Potter
Number 66 (February)
The Role of Consumption Substitutability in the
International Transmission of Shocks, by Cédric Tille
Number 67 (March)
Looking beyond the CEO: Executive
Compensation at Banks, by Rebecca S. Demsetz
and Marc R. Saidenberg
Number 68 (March)
Bank Loan Sales: A New Look at the Motivations for
Secondary Market Activity, by Rebecca S. Demsetz
Number 69 (March)
Determinants of Currency Risk Premiums,
by John A. Carlson and C. L. Osler
Number 70 (March)
Structural Estimates of the U.S. Sacrifice Ratio,
by Stephen G. Cecchetti and Robert W. Rich
Number 71 (March)
The Nature and Growth of Vertical Specialization
in World Trade, by David Hummels, Jun Ishii,
and Kei-Mu Yi
Number 72 (March)
Liquidity in U.S. Fixed Income Markets:
A Comparison of the Bid-Ask Spread in Corporate,
Government, and Municipal Bond Markets,
by Sugato Chakravarty and Asani Sarkar
Number 73 (March)

The views expressed in the publications and papers summarized in Research Update are those of the
authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the
Federal Reserve System.