Macroeconomic Risk Research Articles

Implementing Real Options Valuation under Macroeconomic Risk and Normally Distributed Cash Flows

The paper highlights the encountered problems in implementing real options under more realistic assumptions such as business cycle risk and normally distributed cash flows. The problems considered include (i) estimating empirical distribution of cash flows from real option investments; (ii) investment decisions across business cycles, and (iii) calculating the probability of investing with the above stated rich features. To this end, we estimate operating cash flows of US corporate firms using a Markov chain model under both geometric and arithmetic Brownian motions assumptions for cash flows and develop a valuation model of real option with normally distributed cash flows. Associated investment valuation models incorporating these estimates reveal that critical cash flow levels significantly differ across models and regimes.

Which discount rate for sustainability?

There is a long-standing controversy about determining the discount rate at which companies should discount the long-term benefits of sustainability investments (e.g. for climate change mitigation and adaptation). While financial capital is discounted at the standard financial discount rate, this paper argues that companies should discount social and natural capital at the social discount rate. We add a risk parameter to the social discount rate to deal with the macroeconomic risk of rare disasters. Social discount rates are typically lower than financial discount rates. So, if applied, they should lead to higher investments in social and natural capital.

Forecasting US GDP growth rates in a rich environment of macroeconomic data

Forecasting GDP growth rates is a formidable challenge, compounded by the inherent volatility, the complexity of the economic landscape, and the presence of a multitude of economic indicators at varying data frequencies. This study employs the MIDAS-LASSO model, which represents a penalized approach designed for mixed-frequency data, to forecast US GDP growth rates, while considering a vast array of macroeconomic indicators, including the Macroeconomic Attention Index (MAI) of Fisher et al. (2022). The empirical analysis demonstrates that both macroeconomic indicators and MAI exhibit considerable power for forecasting US GDP growth rates. The MIDAS-LASSO model outperforms its competitors in terms of forecasting efficacy, particularly in scenarios involving a plethora of predictors. Further analysis scrutinizes the model's efficacy across business cycles and during significant economic downturns, and the pathways through which macroeconomic risks influence US GDP growth rates. These insights offer valuable contributions to the field of economic forecasting and present novel avenues for policymakers and analysts.

Portfolio optimization in the stock market under disruptions: Real case studies of COVID-19 pandemic and currency risk

The connection between risk and return is a critical concept in finance. Investors who take on more risk can earn higher returns. Disruptions are part of market risks, also known as systematic risks. Due to political and macroeconomic risks, their effects on the entire economic market, or a significant portion of its sectors, are not negligible. Among these sectors, the stock market is essential as a basis of the economy. The point is that the consequences of all disruptions are not merely unpleasant for companies. They may affect corporate profitability both negatively and positively. Hence, investors who trace companies' news and fundamental conditions react, and the closing price probably encounters volatility. Therefore, the common trend of several stocks may fluctuate. This research investigates how investors in the stock market should form their investment portfolio to see the minor losses when disruptions occur and take advantage of the potential provided profitability by turning threats into opportunities. A three-step framework is presented to achieve this goal. A prerequisite for this framework is the collection of relevant data. Ten stocks from distinct industries of the Securities and Exchange Organization of Iran are chosen for the examination. In the first step, multi-variate regression analysis categorizes selected stocks into the most and the least affected groups. At the same time, a comprehensive technical analysis is involved in this step. Then, in the second step, three well-known machine learning techniques, namely, stacked long short-term memory (Stacked LSTM), autoregressive integrated moving average (ARIMA), and Prophet, are compared from the point of view of predicting future closed prices of selected stocks. The method with the most minor statistical error in forecasting, i.e., root mean squared error (RMSE) and validation loss, estimates the next month's closed prices. Finally, based on the predicted closed prices, the third step empowers the investor to optimize their portfolio in different scenarios, containing various investment weights on the two obtained groups of the first step, using the Markowitz Modern Portfolio Theory. The COVID-19 pandemic and currency risk are the two examined real case studies to validate the proposed methodology. Numerical results based on the Sharp Ratio show the superiority of investing 75 percent of an asset in the most affected stocks and the rest in the least affected stocks in the case of a pandemic and vice versa for the case of currency risk, which reveals that according to the unique features of disruptions investors can benefit from both categories of stocks.

Risk factor aggregation and stress testing

Stress testing refers to the application of adverse financial or macroeconomic scenarios to a portfolio. For this purpose, financial or macroeconomic risk factors are linked with asset returns, typically via a factor model. We expand the range of risk factors by adapting dimension-reduction techniques from unsupervised learning, namely PCA and autoencoders. This results in aggregated risk factors, encompassing a global factor, factors representing broad geographical regions, and factors specific to cyclical and defensive industries. As the adapted PCA and autoencoders provide an interpretation of the latent factors, this methodology is also valuable in other areas where dimension-reduction and explainability are critical.

From macro to micro: Sparse macroeconomic risks and the cross-section of stock returns

Our study presents novel evidence on the pricing effectiveness of macroeconomic risks at the firm level. We employ a sparse PCA approach to aggregate macroeconomic variables from the FRED-MD database and obtain the first eight components, namely inflation, housing, spreads, production, employment, personal income, yields, and credit. We then construct the corresponding firm-level macroeconomic risk exposures as the sensitivity of the individual stock returns to the sparse economic components. Our research yields three main findings: (i) macro betas cannot be fully captured by common firm fundamentals, indicating the unique information in macro betas; (ii) the betas of inflation, production, personal income, yields, and credit are strong predictors of future stock returns beyond other micro risks; and (iii) behavioral mispricing theory, especially arbitrage frictions and investor sentiment, can help explain the macro beta premium.

Reformy instytucjonalne Unii Gospodarczej i Walutowej po 2010 r. – ocena zasadności i efektywności wprowadzonych rozwiązań na gruncie teorii optymalnych obszarów walutowych

INSTITUTIONAL REFORMS OF THE ECONOMIC AND MONETARY UNION IMPLEMENTED AFTER 2010: THE EFFECTIVENESS OF NEW ARRANGEMENTS ON THE GROUNDS OF THE THEORY OF OPTIMUM CURRENCY AREAS The economic shocks over the last 15 years revealed low effectiveness of macroeconomic adjustment mechanisms, as manifested by growing imbalances in the current accounts, public finances, and labour markets of the euro zone economies. The essence of the institutional reforms introduced after 2010 was to improve the mechanisms for stabilizing macroeconomic balances, as well as to increase the resilience of the EMU economies to future disturbances, especially those of a systemic nature. New solutions have a strong basis in the theory of optimum currency areas, as well as in institutional economics. The effects of the new institutional arrangements indicate a substantial improvement in the resilience of credit institutions to economic shocks, however, other macroeconomic risks remain.

The effects of monetary policy on macroeconomic risk

Monetary policy expansions significantly reduce macroeconomic downside risk, measured as the difference between the median and the 5th percentile of the industrial production growth forecast distribution. However, the effects are smaller in magnitude than those of credit spread shocks, which we find to be a major driver of fluctuations in downside risk. As a consequence, large policy interventions are required to stabilize risk originating from the financial sector, with undesirable consequences in terms of both price and output stability. These findings are obtained using US data and a novel econometric approach which combines quantile regressions and Structural VAR analysis.

Institutional framework, macroeconomic instability and financial markets: perspective from emerging economies

Purpose The study evaluates the role of institutional framework and macroeconomic instability on financial market development among emerging economies.Design/methodology/approach The study uses panel data compiled from 32 countries from the sub-region of Sub-Sahara Africa (SSA), covering the period starting from 1996 to 2019. Empirical analyses were carried out using the two-step system generalized method of moments (TS-GMM) statistical framework.Findings Reviewed results suggest that institutional quality, effective governance and corruption control have a significant positive impact on financial market development among economies in the sub-region. Further empirical estimates show that macroeconomic risk and macroeconomic uncertainty have significant adverse effects on financial market development. Additionally, reported empirical estimates suggest that an improved institutional framework has the potential to lessen the adverse effect of macroeconomic instability on financial market development among economies in the sub-region.Originality/value The uniqueness of this empirical inquiry compared to related studies in the present literature stems from the fact that studies employing similar empirical approaches on the subject matter for economies in the sub-region are rare. Additionally, the analysis pursued in this study employs critical variables whose impact on financial market performance in the sub-region has not been examined per our review. These variables include indexes such as macroeconomic risk and institutional quality, which are unique to this study based on their construction; these indexes are generated using a principal component analysis procedure with different underlying variables compared to what may be found in the literature.

Does Political Stability Matter for Foreign Direct Investment in Eurasian countries? Examining the Role of the Business Environment and Macroeconomic Variables

This In recent years, developing countries have placed a strong emphasis on attracting foreign direct investment (FDI), which is ostensibly regarded as the most important external resource for increasing industrial activity and real income growth. Indeed, the subsequent benefits of FDI, one of which is increased economic growth in developing countries, have been widely acknowledged. As a result, the goal of this study was to look into the impact of foreign macroeconomic factors, political instability, and the business environment on foreign direct investment in Eurasia countries. Many developing countries have softened their stances on foreign direct investment (FDI) in the hopes of luring more of this kind of investment and thereby bolstering their economies. This is due to the fact that there are many benefits to utilizing foreign capital during the expansion process. The panel data method was used to analyse information gathered from ten different Eurasia countries over a twenty-six-year period, from 1996 to 2021. The study's findings support the predicted outcomes of the hypothesized research. This study is one of the few in Eurasia countries that can be considered a pioneering study on the subject. This study will help policymakers and researchers understand the relationship between macroeconomic risk, political instability, the business environment, and foreign direct investment.

It Is Time to Reconsider the 3% Discount Rate

ObjectivesHealth technology assessment (HTA) guidance often recommends a 3% real annual discount rate, the appropriateness of which has received limited attention. This article seeks to identify an appropriate rate for high-income countries because it can influence projected cost-effectiveness and hence resource allocation recommendations. MethodsThe author conducted 2 Pubmed.gov searches. The first sought articles on the theory for selecting a rate. The second sought HTA guidance documents. ResultsThe first search yielded 21 articles describing 2 approaches. The “Ramsey Equation” sums contributions by 4 factors: pure time preference, catastrophic risk, wealth effect, and macroeconomic risk. The first 3 factors increase the discount rate because they indicate future impacts are less important, whereas the last, suggesting greater future need, decreases the discount rate. A fifth factor—project-specific risk—increases the discount rate but does not appear in the Ramsey Equation. Market interest rates represent a second approach for identifying a discount rate because they represent competing investment returns and hence opportunity costs.The second search identified HTA guidelines for 32 high-income countries. Twenty-two provide no explicit rationale for their recommended rates, 8 appeal to market interest rates, 3 to consistency, and 3 to Ramsey Equation factors. ConclusionsDeclining consumption growth and real interest rates imply HTA guidance should reduce recommended discount rates to 1.5 to 2+%. This change will improve projected cost-effectiveness for therapies with long-term benefits and increase the impact of accounting for long-term drug price dynamics, including reduced prices attending loss of market exclusivity.

Sector Investing Risks in Different Market Conditions

GICS sector investing is a popular investment style that offers increased liquidity and reduced idiosyncratic risk as compared with investing in individual stocks. This is attested by the increase in trading volumes of ETFs tracking GICS sectors. While most investors are aware of macro-economic risks associated with GICS sectors by virtue of industry type constituting the sector, information about the relative performance of sectors in different market environments is not as keenly understood. For example, most investors know that utilities and consumer staples perform well during recessions; but most are unaware of how the sectors perform relative to one another during inflationary periods or during periods of wide credit spreads. Most of the knowledge about relative sector performance is restricted to associating the economic conditions with recessionary or expansionary phases of the business cycle. Further, individual components of certain sectors behave very differently during certain market periods, forming sub-sectors within the sectors. Investors who are focused on positioning their portfolio for certain market environments may find it beneficial to concentrate their holding in that sub-sector to the extent that it meets their growth mandates while staying within risk tolerance. This work presents a detailed comparison of risk and return characteristics of the 11 GICS sectors in five market environments: business-cycle recession, rising interest rates, rising inflation, high market volatility, and wide credit spreads. Further, it dissects the behavior of individual sector components to glean information about when it may be advisable for sector investors to focus on industry groups within sectors. Looking at the current market environment and the likely evolution of macroeconomic conditions in the near future, it extrapolates the findings to make general recommendations for sector investing in the near future.

A framework for developing and implementing FIT policies for renewable energy based on local economic conditions

Energy policymakers of developing countries are striving to provide adorable, reliable, and cleaner energy for all the sectors of their economies. Feed-In Tariff (FIT) policies have played an important role in attracting independent power producers to invest in energy generation from renewable sources in developed and some developing countries. However, the development and application of the FIT policy framework are not autonomous of national and local fiscal and socio-economic policies. Financial modeling of FIT which considers local economic conditions and the state of the energy sector at the national level can contribute to the development of FIT policies that are relevant, realistic, and sustainable to investment in energy generation from renewable energy sources at the local level. This paper outlines the financial modeling of the FIT rates using a solar farm in Malawi as a case study. The results show that a shift from a fixed price model to a fixed price model with full or partial inflation adjustment considering the volatile inflation rate and macroeconomic risks in a fragile economy can effectively attract and increases private investments in the energy sector. Consequently, the financial modeling of FIT can enhance the generation of strategic information that can be used for the development of FIT policies that are relevant, realistic, and sustainable in the context of local economic conditions.

Seasonal variation in risk and return trade‐off

AbstractExisting studies show that firms with large macroeconomic risk do not earn higher returns, incompatible with the theoretical predictions of standard economic models. Using a broad set of macro‐related factors, we find the January seasonality of the macroeconomic risk–return relation. Firms with high macro risk deliver higher returns than firms with low risk in January, that is, the positive risk–return trade‐off holds. Conversely, the negative risk–return relation is observed in non‐January months. The seasonal variation in the macro risk–return relation cannot be explained by existing January effects, including the tax‐loss selling, window dressing, and pronounced gambling preference around New Year.

ESG ratings and macroeconomic risks in the Asian emerging stock markets

ABSTRACT We examine how equity returns of ESG-rated firms in the emerging Asian market respond to the impact of macroeconomic shocks. By studying companies across nine emerging Asian countries, we find no evidence of an outperforming pattern in the stock returns of strong ESG-performing firms. However, we observe that strong ESG-performing firms tend to have less volatility in their equity returns, while weak ESG-performing firms exhibit more volatile equity returns. When it comes to the influence of macroeconomic factors on ESG-rated firms, we highlight the significant impact of demand shocks on the stock values of ESG companies, especially in the case of weaker ESG firms. Thus, our findings suggest that in emerging markets, firms with high ESG ratings tend to safeguard their equity prices against demand shocks and fluctuations in equity values, setting them apart from their low ESG-rated counterparts.

El Salvador: uma análise da lei de integração monetária e da lei do bitcoin

ABSTRACT The objective of this article is to analyze the two most important monetary laws that have been implemented in El Salvador, namely the Monetary Integration Law (MIL) and the Bitcoin Law. The most important articles of both laws will be analyzed, as well as the consequences of dollarization, and the possible advantages and risks associated with the adoption of Bitcoin as legal tender. Although this measure may have some positive aspects by encouraging financial innovation and facilitating remittances, the macroeconomic risk is very high due to the volatility of this cryptocurrency. So far no positive results have been achieved as the acceptance has been very low and there has been a depreciation of the asset in recent months.

ВПЛИВ МАКРОЕКОНОМІЧНИХ РИЗИКІВ НА ПРОЦЕДУРУ КРИТЕРІАЛЬНОГО ФОРМУВАННЯ ФІНАНСОВОЇ СТІЙКОСТІ ПІДПРИЄМСТВА

The authors determine the influence of macroeconomic risks on the procedure of criterion formation of the financial stability of the enterprise. The article examines macroeconomic risks that have a significant impact on the financial stability of the enterprise. To ensure it, it is necessary to constantly monitor the macroeconomic situation and adapt the company's financial strategies to the conjunctural changes in the market, as well as take into account the factors of influence of macroeconomic indicators on the financial stability of enterprises. It was established that the main detailed elements of the process of criterial formation of the financial stability of enterprises include scenario analysis, analysis of the macroeconomic environment, diversification of assets, financial reserves, risk management strategy. Ways to overcome the problems of the influence of macroeconomic risks on the procedure of criterion formation of the financial stability of the enterprise in the modern market economic environment are indicated. Inflation, which contributes to the increase in the prices of goods and services, reduces the purchasing power of the enterprise and increases its costs. A sharp fluctuation in exchange rates can significantly change the profitability of export-import operations, which negatively affects financial stability. Since changes in exchange rates are unpredictable, it complicates the forecasting and planning of financial flows. An increase in interest rates leads to an increase in the cost of loan capital, which reduces the profitability of the enterprise and its opportunities for development. Economic fluctuations in the market environment can lead to the emergence of economic crises, recessions or a decrease in the general level of economic growth can lead to a decrease in demand for the company's products. To ensure optimal provision of financial stability, it is necessary to constantly monitor the macroeconomic situation and adapt the company's financial strategies to market changes. Therefore, in the process of forced adaptation to new conditions in order to maintain financial stability, enterprises are forced to constantly adapt to changes in the macroeconomic environment, which may require cost reduction, restructuring of liabilities, liquidation of debts or changes in production processes.

Macroprudential policy in retail lending: Concept and results – a case study of the Bank of Russia

Macroprudential regulation of the banking system is a significant instrument for ensuring the financial stability of the state. Unsecured consumer lending is growing at a steadily high rate (in August-October 2022, the average monthly debt growth was 0.9%), and it remains a priority segment for banks because of its high margins. The share of unsecured consumer loans provided to borrowers with debt burden indicator (DBI) of more than 80% amounted to more than 32% in the third quarter of 2022 (28% in the second quarter of 2022). The share of consumer loans for a term of more than 5 years remains at a high level (15% in July-September 2022). The share of MFO loans issued to borrowers with a DBI of more than 80% was 41% in the second quarter of 2022 (38% in the first quarter of 2022). A further increase in the citizens’ debt burden in the context of the economy restructuring may create additional macroeconomic risks. Problems of citizens with servicing loans and borrowings can lead to a reduction in demand in the economy, and losses of banks as a result of writing off “bad” loans can lead to a decrease in their ability to lend to the economy. To limit the risks associated with an increase in the citizens’ debt burden, since the first quarter of 2023, the Bank of Russia has established direct quantitative restrictions on the issuance of certain types of credits (loans) and the application of increased buffers to risk coefficients if creditors exceed established limits. This article discusses the main approaches to implementation of the macroprudential policy of the Central Bank of the Russian Federation, its goals and instruments, and peculiarities of application in the current conditions.

Questions on Cost-Benefit Analysis and a Discussion of Present Answers: How Should One Determine the Social Discount Rate to Be Announced?

In the wake of the CBA used for public investment programming in France, new recommendations have been formulated for projects whose advantages (costs or benefits) are exposed to macroeconomic risks (correlation with GDP per capita), distinguishing between classically Gaussian hazards and “rare disasters” à la Barro. Taking rare disasters into account significantly modifies the value of the discount rate, along with the mathematical expectation of the advantages, and accentuates the distinction between procyclical and counter-cyclical projects.

Non-Financial Markets and Interconnectedness between US and Emerging Financial Economies: Evidence from Covid-19 Financial Crisis

During times of financial turmoil, when traditional assets experience significant volatility, commodity markets provide diversification benefits to investors. The objective is to investigate the factors influencing financial contagion between the United States and emerging Asian equity markets (China and India). The study analyzes the influential impact of the volatility index, gold, oil, and USD index on financial contagion among the markets. The dynamic conditional correlation analysis is utilized to explore the correlations during the US subprime and Covid-19 crises, and quantile regression analysis is conducted at different levels of time-varying correlations. The study's results suggest that financial contagion becomes more pronounced during periods of financial turmoil, and global financial crises contribute to alterations in the dependence structure between financial contagion among equity markets and global macroeconomic risk factors. The effect of financial contagion can be abridged through altering portfolio reallocation strategies according to investors’ risk appetite during high market volatility.