Reduced-form Approach Research Articles

The costs and benefits of leaving the EU: trade effects

This paper estimates the welfare effects of Brexit, focusing on trade and fiscal transfers. We use a standard quantitative general equilibrium trade model with many countries and sectors and trade in intermediates, as in Costinot and Rodriguez-Clare (2014). We simulate a range of counterfactuals reflecting alternative options for EU-UK relations following Brexit. Welfare losses for the average UK household are 1.3% if the UK remains in the EU's Single Market like Norway (a “soft Brexit”).Losses rise to 2.7% if the UK trades with the EU under World Trade Organization rules (a “hard Brexit”). A reduced form approach that captures the dynamic effects of Brexit on productivity more than riples these losses and implies a decline in average income per capita of between 6.3% and 9.4%, partly via falls in foreign investment. These negative effects are widely shared across the entire income distribution and are unlikely to be offset from new trade deals.

A structural model of cost pass-through: the case of the US yogurt retailing

We provide a structural framework for retail cost pass-through based on a neoclassical inverse demand model and retail profit maximization conditions. Unlike previous literature where game-theoretic structures are imposed on cost pass-through, our framework allows for estimating cost pass-through and the degree of market competition simultaneously. Further, our model incorporates potential cross-brand effects representing demand substitution and strategic complementarity effects. Our model supplements the traditional reduced-form approach to pass-through and is applicable in environments, where the lack of brand-level cost data renders reduced-form analysis infeasible. The empirical value of our model is illustrated in an econometric analysis of retail pass-through for national and store brand yogurt. Our results indicate that: (1) market competition has a positive impact on own-brand cost pass-through, especially for national brands, and (2) overlooking cross-brand effects results in biased own-brand pass-through estimates. Finally, we provide a graphical illustration of the relationship between cost pass-through and market competition.

Pricing credit derivatives under fractional stochastic interest rate models with jumps

Based on the reduced-form approach, this paper investigates the pricing problems of default-risk bonds and credit default swaps (CDSs) for a fractional stochastic interest rate model with jump under the framework of primary-secondary. Using properties of the quasi-martingale with respect to the fractional Brownian motion and the jump technique in Park (2008), the authors first derive the explicit pricing formula of defaultable bonds. Then, based on the newly obtained pricing formula of defaultable bonds, the CDS is priced by the arbitrage-free principle. This paper presents an extension of the primary-secondary framework in Jarrow and Yu (2001).

Economic costs of aggressive climate policy

ABSTRACTWhether aggressive climate policy is warranted crucially depends on the economic costs of emission cuts. Different from previous studies, this study estimates the economic costs of emission costs with a reduced-form approach. The major advantages of this approach are its simplicity and less assumption dependence. Based on the study’s parameter estimates, it is found that a 25% aggressive reduction in CO2 emissions from 1990 levels will lead to a 3.69% decrease in the combined GDP of developed OECD countries. Although the cost is significant, in relation to the benefits of such policy, this study’s finding still suggests that nations should implement more aggressive climate policy.

Microfoundations for Performance, Competition and Econometric Implications

We consider two agency-theory-based structural models and a reduced form model of bank inefficiency. The two structural models assume that the inefficiencies and quantities are sequentially and simultaneously determined, respectfully. The reduced form model assumes that inefficiency of a bank depends on other banks' inefficiencies. We argue that conventional stochastic frontier models would give inconsistent parameter estimates as they ignore systematic nature of managerial decision making process. We estimate the inefficiencies of Eurozone banks using our novel structural and reduced form approaches that calls for certain MCMC techniques. Bayes factor favors the sequential model where the efficiency is determined first. In the empirical application for the Eurozone, we find a pick in structural and non-structural inefficiency after the financial crisis and considerable variability across Member States. A way of tackling such banking imbalances is to move towards a banking union.

Comment on “Explaining the Standard of Proof in Criminal Law: A New Insight”

Comment on “Explaining the Standard of Proof in Criminal Law: A New Insight”

Economic consequences of aviation system disruptions: A reduced-form computable general equilibrium analysis

The state of the art approach to economic consequence analysis (ECA) is computable general equilibrium (CGE) modeling. However, such models contain thousands of equations and cannot readily be incorporated into computerized systems to yield rapid estimates of economic impacts of various types of transportation system failures due to natural hazards, terrorist attacks or technological accidents. This paper presents a reduced-form approach to simplify the analytical content of CGE models and make them more transparent and enhance their utilization potential. The reduced-form CGE analysis is conducted by first running simulations one hundred times, varying key parameters, such as the magnitude of the initial shock, duration, location, behavioral responses, and resilience, according to a Latin Hypercube sampling procedure. Statistical analysis is then applied to the “synthetic data” results in the form of both ordinary least-squares and quantile regression. The analysis yields linear equations that are incorporated into a computerized system and utilized along with Monte Carlo simulation methods for propagating uncertainties in economic consequences. Although our demonstration and discussion focuses on aviation system disruptions caused by terrorist attacks, the approach can be applied to a broad range of threat scenarios.

How does Emigration affect Labor Markets? Evidence from Road Construction in Brazil

We study the impact of emigration on local labor markets, based on the construction of a 1,087km road in northeastern Brazil. The new road has changed population substantially, creating new cities along its path and increasing internal migration flows. We first use a reduced-form approach to estimate the effect of emigration on skill groups (defined by education and experience) - a 10 percentage point increase in the proportion of emigrants raises wages by 5%. Then, using a structural approach, we estimate cross effects among groups - although emigration typically raises wages, complementary effects determine negative impacts in some municipalities.

The Reduced Form of Litigation Models and the Plaintiff’s Win Rate

AbstractThis paper introduces the reduced-form approach to litigation selection models. A reduced form comprises a joint distribution of parties’ beliefs about the probability that a plaintiff woul...

A reduced-form approach for representing the impacts of wind and solar PV deployment on the structure and operation of the electricity system

In many climate change mitigation scenarios, integrated assessment models of the energy and climate systems rely heavily on renewable energy technologies with variable and uncertain generation, such as wind and solar PV, to achieve substantial decarbonization of the electricity sector. However, these models often include very little temporal resolution and thus have difficulty in representing the integration costs that arise from mismatches between electricity supply and demand. The global integrated assessment model, MESSAGE, has been updated to explicitly model the trade-offs between variable renewable energy (VRE) deployment and its impacts on the electricity system, including the implications for electricity curtailment, backup capacity, and system flexibility. These impacts have been parameterized using a reduced-form approach, which allows VRE integration impacts to be quantified on a regional basis. In addition, thermoelectric technologies were updated to include two modes of operation, baseload and flexible, to better account for the cost, efficiency, and availability penalties associated with flexible operation. In this paper, the modeling approach used in MESSAGE is explained and the implications for VRE deployment in mitigation scenarios are assessed. Three important stylized facts associated with integrating high VRE shares are successfully reproduced by our modeling approach: (1) the significant reduction in the utilization of non-VRE power plants; (2) the diminishing role for traditional baseload generators, such as nuclear and coal, and the transition to more flexible technologies; and (3) the importance of electricity storage and hydrogen electrolysis in facilitating the deployment of VRE.

Does Modeling Framework Matter? A Comparative Study of Structural and Reduced-Form Models

This study provides a rigorous empirical comparison of structural and reduced-form credit risk frameworks. The literature differentiates between structural models that are based on modeling of the evolution of the balance sheet of the issuer, and reduced-form models that specify credit risk exogenously by a hazard rate process. Until now, there has been no common agreement in academia and practice on which model framework better captures credit risk. As major difference we focus on the discriminative modeling of the default time. In contrast to the previous literature, we calibrate both approaches to the same data set, apply comparable estimation techniques, and assess the out-of-sample prediction quality on the same time series of CDS prices. As our empirical implementations of both approaches rely on the same market information we are able to judge whether empirically the model structure itself makes an important difference. Interestingly, our study shows that the models' prediction power are quite close on average indicating that for pricing purposes the modeling type does not greatly matter compared to the input data used. Still, the reduced-form approach outperforms the structural for investment-grade names and longer maturities. In contrast the structural approach performs better for shorter maturities and sub-investment grade names.

International aspects of merger policy: A survey

This paper surveys the literature on merger policy in open economies. We first adopt a reduced-form approach to derive general insights on the scope for conflict between national antitrust authorities and on the gains from international merger policy coordination. Taking trade costs as given, we use standard oligopoly models to derive conditions on market structure, under which underenforcement or overenforcement of national merger policies can arise. We then study the interactions between merger policy and trade policy, and find that trade liberalization often leads to stricter national merger policies. We conclude by discussing empirical evidence on conflict between antitrust authorities.

Enhanced equity-credit modelling for contingent convertibles

Contingent convertible (CoCo) bonds are characterized by forced equity conversion under either an accounting or regulatory trigger. The accounting trigger occurs when the capital ratio of the issuing bank falls below some contractual threshold. Under the regulatory trigger, sometimes called the point-of-non-viability (PONV) trigger, the regulatory authority may enforce equity conversion when the financial health of the bank deteriorates to certain distressed level. In this paper, we propose an equity-credit modelling of the joint process of the stock price and the capital ratio that integrates both a structural approach for the accounting trigger and a reduced-form approach for the PONV trigger of equity conversion. We also construct effective Fortet algorithms and finite difference schemes for numerical pricing of CoCo bonds under various forms of equity conversion pay-off. The pricing properties of CoCo bonds are examined under different assumptions for the state-dependent intensity of the PONV trigger, the contractual specifications and market conditions.

A Structural Jump Threshold Framework for Credit Risk

This paper presents a new structural framework for multidimensional default risk. We define the time of default as the first time the log-return of the stock price of a firm jumps below a (possibly nonconstant) default level. When stock prices are exponential Levy, this framework is equivalent to a reduced form approach, where the intensity process is parametrized by a Levy measure. The dependence between the default times of firms within a basket of credit securities is the result of the jump dependence of their respective stock prices, making the link between the equity and credit markets. We value a first-to-default basket credit default swap (CDS) as an application.

Inflation persistence: revisited

This paper presents evidence on the persistence of inflation in the USA over the period 1949-2014. Of particular interest is whether the persistence of inflation has changed over that time period. We use a reduced form approach to measuring inflation persistence, modelling inflation as an autoregressive process. We measure persistence as the half-life of a shock to that process. Our analysis employs both a Frequentist approach and a Bayesian approach to identify breaks in inflation persistence. Both our Frequentist and Bayesian results indicate that inflation persistence has undergone significant changes over the past 60 years.

Regional Labor Market Differences in Brazil and Search Frictions: Some Structural Estimates

We estimate an equilibrium job search model for six metropolitan areas located in different regions of Brazil. Two mechanisms of wage determination are considered: wage posting by monopsony firms and Nash bilateral bargaining. In order to estimate the model, we use the non-parametric method developed by Bontemps, Robin, & van den Berg [2000. Equilibrium search with continuous productivity dispersion: Theory and nonparametric estimation. International Economic Review, 41(2), 305-358]. There is significant heterogeneity among the estimated structural parameters for these regions. We succeed in rationalizing some well-known regional differences in wages, unemployment rates and productivity prevalent in Brazilian labor markets, thus offering new interpretations. Metropolitan regions in the Northeast have much lower λ0 (arrival rate of wage offers for unemployed workers) andλ1 (arrival rate of wage offers for employed workers) vis a vis areas in the South or Southeast regions. This is a new, and much more precise, result worth considering on the regional inequality debate in Brazil. Regional inequality in wages, besides being an outcome of its regional human capital distribution, can be rationalized as inequality of search frictions brought by differences inλ1. We found a key (indirect) role for search frictions when analysing productivity differences as well. Since search frictions impact simultaneously on monopsony power as well as on productivity, in order to understand better regional productivity differences we must deepen our analysis on how these structural parameters are differentiated by regions. Labor market frictions add important insights into the regional debate, something not captured by more traditional econometric reduced form approaches.

Economic Consequences of Aviation System Disruptions: A Reduced-Form Computable General Equilibrium Analysis

The state of the art approach to economic consequence analysis (ECA) is computable general equilibrium (CGE) modeling. However, such models contain thousands of equations and cannot readily be incorporated into computerized systems used by policy analysts to yield estimates of economic impacts of various types of transportation system failures due to natural hazards, terrorist attacks or technological accidents. This paper presents a reduced-form approach to simplify the analytical content of CGE models to make them more transparent and enhance their utilization potential. The reduced-form CGE analysis is conducted by first running simulations one hundred times, varying key parameters, such as magnitude of the initial shock, duration, location, remediation, and resilience, according to a Latin Hypercube sampling procedure. Statistical analysis is then applied to the “synthetic data” results in the form of both ordinary least squares and quantile regression. The analysis yields linear equations that are incorporated into a computerized system and utilized along with Monte Carlo simulation methods for propagating uncertainties in economic consequences. Although our demonstration and discussion focuses on aviation system disruptions caused by terrorist attacks, the approach can be applied to a broad range of threat scenarios.

Enhanced Equity-Credit Modeling for Contingent Convertibles

Contingent convertible (CoCo) bonds are characterized by forced equity conversion under either accounting or regulatory trigger. Accounting trigger occurs when the capital ratio of the issuing bank falls below some contractual threshold. Under the regulatory trigger, sometimes called the point-of-non-viability (PONV) trigger, the regulatory authority may enforce equity conversion when the financial health of the bank deteriorates to certain distressed level. In this paper, we propose an equity-credit modeling of the joint process of the stock price and capital ratio that integrates both the structural approach of accounting trigger and reduced form approach of PONV trigger of equity conversion. We also construct effective Fortet algorithms and finite difference schemes for numerical pricing of CoCo bonds under various forms of equity conversion payoff. The pricing properties of the CoCo bonds under different assumptions of the state dependent intensity of PONV trigger, contractual specifications and market conditions are examined.

Use of high-order sensitivity analysis and reduced-form modeling to quantify uncertainty in particulate matter simulations in the presence of uncertain emissions rates: A case study in Houston

Abstract Regional air quality models are widely used to evaluate control strategy effectiveness. As such, it is important to understand the accuracy of model simulations to establish confidence in model performance and to guide further model development. Particulate matter with aerodynamic diameter less than 2.5 μm (PM2.5) is regulated as one of the criteria pollutants by the National Ambient Air Quality Standards (NAAQS), and PM2.5 concentrations have a complex dependence on the emissions of a number of precursors, including SO2, NOx, NH3, VOCs, and primary particulate matter (PM). This study quantifies how the emission-associated uncertainties affect modeled PM2.5 concentrations and sensitivities using a reduced-form approach. This approach is computationally efficient compared to the traditional Monte Carlo simulation. The reduced-form model represents the concentration-emission response and is constructed using first- and second-order sensitivities obtained from a single CMAQ/HDDM-PM simulation. A case study is conducted in the Houston-Galveston-Brazoria (HGB) area. The uncertainty of modeled, daily average PM2.5 concentrations due to uncertain emissions is estimated to fall between 42% and 52% for different simulated concentration levels, and the uncertainty is evenly distributed in the modeling domain. Emission-associated uncertainty can account for much of the difference between simulation and ground measurements as 60% of observed PM2.5 concentrations fall within the range of one standard deviation of corresponding simulated PM2.5 concentrations. Uncertainties in meteorological fields as well as the model representation of secondary organic aerosol formation are the other two key contributors to the uncertainty of modeled PM2.5. This study also investigates the uncertainties of the simulated first-order sensitivities, and found that the larger the first-order sensitivity, the lower its uncertainty associated with emissions. Sensitivity of PM2.5 to primary PM has the lowest uncertainty while sensitivity of PM2.5 to VOC has the highest uncertainty associated with emission inputs.

Corporate Asset Pricing Models and Debt Contracts

In the past decades financial markets rapidly gained on complexity due to an increased demand for risk diversification and hedging. A number of sophisticated instruments was developed that capture various aspects of price movements, correlations of assets, macro-economic developments, and other changes that might affect the future income generated by the considered securities. The pricing of these securities was not sufficiently accurate using the traditional asset pricing models. In the search for new methods two different approaches appeared. One stream of literature (called the reduced-form approach) focused on finding a purely mathematical way of asset pricing, without the effort of finding any economical intuition behind the models. In contrast, the other group of academics studied the firm and its evolution. These, so-called structural models have an intuitive connection to the underlying economics, and therefore they can be helpful in understanding the reasons of price movements. This work fits in the category of structural approaches.