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Recent Research: Highlights from February 2012

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"Measuring and Modeling Execution Cost and Risk"
The Journal of Portfolio Management (Winter 2012)
Robert Engle, Robert Ferstenberg, and Jeffrey Russell

Financial markets are considered to be liquid if a large quantity can be traded quickly and with minimal price impact. Although the idea of a liquid market involves both a cost as well as a time component, most measures of execution costs tend to focus on only a single number that reflects average costs and do not explicitly account for the temporal dimension of liquidity. In practice, trading takes time because larger orders are often broken up into smaller transactions or because of price limits. Recent work shows that the time taken to transact introduces a risk component in execution costs. In this setting, the decision can be viewed as a risk–reward trade-off faced by the investor who can solve for a mean-variance utility-maximizing trading strategy. Engle, Ferstenberg, and Russell introduce an econometric method to jointly model the expected cost and risk of the trade, thereby characterizing the mean-variance tradeoffs associated with different trading approaches, given market and order characteristics. They apply their methodology to a novel dataset and show that the risk component is a nontrivial part of the transaction decision.

"Are We Out of the Woods Yet? Economic and Real Estate Markets in 2011"
The Journal of Structured Finance (Winter 2012)
Mark Fleming

We seem to be basically moving sideways. The risk of a double-dip recession is fading from summer highs, but growth is still elusive. The housing market itself is beset by headwinds. Specifically the persistence of negative equity and the shadow inventory are likely to drag down any gains in housing for a number of years. When housing will rise again will depend on the economy.

"Is the ‘Euro Bond’ the Answer to the Euro Sovereign Debt Crisis? What Outcome Can Investors Expect from Europe?"
The Journal of Wealth Management (Spring 2012)
Kenneth Matziorinis

This article analyzes the causes of the sovereign debt crisis in the euro zone and examines the policy alternatives confronting euro area governments. The author suggests that pooling fiscal risks, creating an EU Treasury, and issuing jointly backed euro bonds would be an optimal solution and the inevitable conclusion of the economic integration project in Europe. The author examines the advantages and disadvantages of euro bonds and concludes that issuing euro bonds would transform a market that is fragmented along national lines into a single unified European government bond (EGB) market with the same depth, breadth, and liquidity as the US Treasury market. By enhancing the size and liquidity of the EGB market, global investors and wealth managers would be able to use euro bond instruments as a tool for payment or transaction needs as well as short-term precautionary and investment balances, which would increase the demand for them and lower their yields. This development would allow the euro area to extract “seigniorage” benefits similar to those that the US has enjoyed in the post–World War II period, which would lower funding costs even for fiscally strong euro area countries. It would also consolidate the euro as one of the world’s two principal reserve currencies. The risk that fiscally weak area countries might take advantage of low borrowing costs to increase debt could easily and effectively be mitigated by agreeing on a formula that would establish an escalating rate in the sharing of interest costs that would be proportional to their debt–GDP ratios. Thus, moral hazard would be mitigated, and incentives would be created to reduce debt and increase income.

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