Intertemporal Choices in Financial Capital Markets

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Overview of the Capital Markets in Vietnam and Directions for Development May 2006 2 This report reflects the state of Vietnam’s capital markets as of the end of October 2005. The report disseminates the findings of work in progress to encourage the exchange of ideas about development issues. The report carries the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. 3 Table of Contents 1 Introduction 11 1.1 Objectives 11 1.2 Methodology 11 1.3 The Structure of the Report 11 2 Macroeconomic Overview 12 2.1 Current Situation and Discussion 12 2.2 Conclusion and Recommendations 13 3 Financial Market Overview 15 3.1 Current Situation and Discussion 15 3.2 Conclusion and Recommendations 17 4 Capital Market Environment 18 4.1 SOE equitization 18 4.2 Foreign Direct Investment 24 4.3 Private sector development 25 4.4 Conclusion and Recommendations 26 5 Operations of Capital Markets 29 5.1 Regulatory framework 29 5.2 Market activities 32 5.3 Conclusion and Recommendations 39 6 Two Principal Problems for Capital Market Development 41 6.1 Management of the secondary market for government securities 41 6.2 Weak incentive for financing in Vietnam’s securities markets 45 6.3 Conclusion and Recommendations 48 7 Policy & Institutional issues 49 7.1 A lack of coherent structural design of the financial sector 49 7.2 Insufficient financial statistics and lack of information sharing 50 7.3 Conclusion and Recommendations 51 8 Formulate formal and simple rules for information sharing. Recommendations for the Five-year Plan 52 8.1 Private-sector initiatives for market development 52 8.2 Policy impacts of capital market development 52 8.3 Policy inputs and outputs 53 8.4 Priority and sequence 53 8.5 Monitoring of Market Development 54 4 List of Tables Table 1: GDP Data of ASEAN+3 countries 12 Table 2: Selected Macroeconomic Data of Vietnam 13 Table 3: Selected Financial Sector Data of Vietnam 15 Table 4: Private Sector Share of GDP in Years from the Start of Privatization 21 Table 5: Private Sector Share of GDP in Selected Transition Countries 23 Table 6: Sector Share of GDP by Ownership in Vietnam 23 Table 7: Private Sector Share of Employment in Selected Transition Countries 23 Table 8: FDI Projects Licensed 1998-2005 1, 2 24 Table 9: Business Factor Distribution by Type of Business in 2003 (%) 25 Table 10: Comparative Chart of SOE Equitization and Capital Markets 27 Table 11: Evolution of Capital Market Regulatory Framework in Vietnam 29 Table 12: Trading Values and Their Profile on HOSTC in 2004 31 Table 13: Securities Firms - Their Capital, Licenses and Affiliations 34 Table 14: Sizes and Liquidity Levels of Bond Markets in ASEAN+3 41 Table 15: Government Securities Issue Amounts byChannels & Methods 43 Table 16: Capital Allocated to the Private Sector by Capital Markets and Bank Loans 44 List of Figures Figure 1: Private Intertemporal Choices in Financial Capital Markets Intertemporal Choices in Financial Capital Markets By: OpenStaxCollege Rates of saving in America have never been especially high, but they seem to have dipped even lower in recent years, as the data from the Bureau of Economic Analysis in [link] show A decision about how much to save can be represented using an intertemporal budget constraint Household decisions about the quantity of financial savings show the same underlying pattern of logic as the consumption choice decision and the labor-leisure decision Personal Savings as a Percentage of Personal Income Personal savings were about to 11% of personal income for most of the years from the late 1950s up to the early 1990s Since then, the rate of personal savings has fallen substantially, although it seems to have bounced back a bit since 2008 (Source: http://www.bea.gov/ newsreleases/national/pi/pinewsrelease.htm) The discussion of financial saving here will not focus on the specific financial investment choices, like bank accounts, stocks, bonds, mutual funds, or owning a house or gold coins The characteristics of these specific financial investments, along with the risks and tradeoffs they pose, are detailed in the Labor and Financial Markets chapter Here, the focus is saving in total—that is, on how a household determines how much 1/11 Intertemporal Choices in Financial Capital Markets to consume in the present and how much to save, given the expected rate of return (or interest rate), and how the quantity of saving alters when the rate of return changes Using Marginal Utility to Make Intertemporal Choices Savings behavior varies considerably across households One factor is that households with higher incomes tend to save a larger percentage of their income This pattern makes intuitive sense; a well-to-do family has the flexibility in its budget to save 20–25% of income, while a poor family struggling to keep food on the table will find it harder to put money aside Another factor that causes personal saving to vary is personal preferences Some people may prefer to consume more now, and let the future look after itself Others may wish to enjoy a lavish retirement, complete with expensive vacations, or to pile up money that they can pass along to their grandchildren There are savers and spendthrifts among the young, middle-aged, and old, and among those with high, middle, and low income levels Consider this example: Yelberton is a young man starting off at his first job He thinks of the “present” as his working life and the “future” as after retirement Yelberton’s plan is to save money from ages 30 to 60, retire at age 60, and then live off his retirement money from ages 60 to 85 On average, therefore, he will be saving for 30 years If the rate of return that he can receive is 6% per year, then $1 saved in the present would build up to $5.74 after 30 years (using the formula for compound interest, $1(1 + 0.06)30 = $5.74) Say that Yelberton will earn $1,000,000 over the 30 years from age 30 to age 60 (this amount is approximately an annual salary of $33,333 multiplied by 30 years) The question for Yelberton is how much of those lifetime earnings to consume during his working life, and how much to put aside until after retirement This example is obviously built on simplifying assumptions, but it does convey the basic life-cycle choice of saving during working life for future consumption after retirement [link] and [link] show Yelberton’s intertemporal budget constraint Yelberton’s choice involves comparing the utility of present consumption during his working life and future consumption after retirement The rate of return that determines the slope of the intertemporal budget line between present consumption and future consumption in this example is the annual interest rate that he would earn on his savings, compounded over the 30 years of his working life (For simplicity, we are assuming that any savings from current income will compound for 30 years.) Thus, in the lower budget constraint line on the figure, future consumption grows by increments of $574,000, because each time $100,000 is saved in the present, it compounds to $574,000 after 30 years at a 6% interest rate If some of the numbers on the future consumption axis look bizarrely large, remember that this occurs because of the power of compound interest over substantial 2/11 Intertemporal Choices in Financial Capital Markets periods of time, and because the figure is grouping together all of Yelberton’s saving for retirement over his lifetime Yelberton’s Choice: The Intertemporal Budget Set Yelberton will make a choice between present and future consumption With an annual rate of return of 6%, he decides that his utility will be highest at point B, which represents a choice of $800,000 in present consumption and $1,148,000 in future consumption When the annual rate of return rises to 9%, the intertemporal budget constraint pivots up Yelberton ...SMBG-EDUNIVERSAL S.A - 18/20, Avenue Gabriel Peri - 93100 Montreuil-sous-Bois - Tel.+33 1 48 57 97 44/ Fax: +33 1 48 58 36 41 SIRET: 399 207 729 00035 / Capital social: 368 620,25 EUR Financial Markets - WORLDWIDE Best Masters Ranking in Financial Markets Country Rank School / Programme 1. 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The University of Melbourne – Graduate School of Business And Economics Master of Quantitative Analysis in Financial Markets ASSET-PRICING AND RISK MANAGEMENT DATA-DRIVEN FINANCIAL MODELS MODEL CALIBRATION AND VOLATILITY SMILES Marco Avellaneda Editor Collected papers of the New York University Mathematical Finance Seminar, Volume II World Scientific Quantitative Analysis in Financial Markets Collected papers of the New York University Mathematical Finance Seminar, Volume II QUANTITATIVE ANALYSIS IN FINANCIAL MARKETS: Collected Papers of the New York University Mathematical Finance Seminar Editor: Marco Avellaneda (New York University) Published Vol. 1: ISBN 981-02-3788-X ISBN 981-02-3789-8 (pbk) Quantitative Analysis in Financial Markets Collected papers of the New York University Mathematical Finance Seminar, Volume II Editor Marco Avellaneda Professor of Mathematics Director, Division of Quantitative Finance Courant Institute New York University m World Scientific II Singapore • New Jersey •London • Hong Kong Published by World Scientific Publishing Co. Pte. Ltd. P O Box 128, Farrer Road, Singapore 912805 USA office: Suite IB, 1060 Main Street, River Edge, NJ 07661 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. QUANTITATIVE ANALYSIS IN FINANCIAL MARKETS: Collected Papers of the New York University Mathematical Finance Seminar, Volume II Copyright © 2001 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. ISBN 981-02-4225-5 ISBN 981-02-4226-3 (pbk) Printed in Singapore by Fulsland Offset Printing INTRODUCTION It is a pleasure to edit the second volume of papers presented at the Mathema- tical Finance Seminar of New York University. These articles, written by some of the leading experts in financial modeling cover a variety of topics in this field. The volume is divided into three parts: (I) Estimation and Data-Driven Models, (II) Model Calibration and Option Volatility and (III) Pricing and Hedging. The papers in the section on "Estimation and Data-Driven Models" develop new econometric techniques for finance and, in some cases, apply them to deriva- tives. They showcase several ways in which mathematical models can interact with data. Andrew Lo and his collaborators study the problem of dynamic hedging of contingent claims in incomplete markets. They explore techniques of minimum- variance hedging and apply them to real data, taking into account transaction costs and discrete portfolio rebalancing. These dynamic hedging techniques are called "epsilon-arbitrage" strategies. The contribution of Yacine Ait-Sahalia Diasporas & Development policy project DiasporaInvestmentin DevelopingandEmerging CountryCapitalMarkets: PatternsandProspects By Aaron Terrazas     Diaspora Investment in Developing and Emerging Country Capital Markets: Patterns and Prospects                  Diaspora Investment in Developing and Emerging Country Capital Markets: Patterns and Prospects.   Acknowledgments                      Table of Contents Executive Summary I. Introduction  II. Capital Markets and Development III. What Is the Role of Diasporas?     IV. Options and Investment Vehicles       Herd Behavior in Financial Markets SUSHIL BIKHCHANDANI and SUNIL SHARMA * This paper provides an overview of the recent theoretical and empirical research on herd behavior in financial markets. It looks at what precisely is meant by herding, the causes of herd behavior, the success of existing studies in identifying the phenomenon, and the effect that herding has on financial markets. [JEL G1, G2, F4] “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Charles Mackay (1841) I n the aftermath of several widespread financial crises, “herd” has again become a pejorative term in the financial lexicon. Investors and fund managers are portrayed as herds that charge into risky ventures without adequate informa- tion and appreciation of the risk-reward trade-offs and, at the first sign of trouble, flee to safer havens. Some observers express concern that herding by market participants exacerbates volatility, destabilizes markets, and increases 279 IMF Staff Papers Vol. 47, No. 3 © 2001 International Monetary Fund MV PY= Es s tt − +1 PPS= * QEPVQ X t t =+ () +1 y p =+ ( β 1 = + ( ) Fi S ** LY i= ( , Y SP P * ,, εε+> * * Sushil Bikhchandani is a Professor at the Anderson Graduate School of Management, UCLA, and Sunil Sharma is Deputy Chief of the European Division at the IMF Institute. Many people, including an anonymous referee, provided useful comments. In particular, the authors would like to thank Ralph Chami, Leonardo Felli, Bob Flood, David Hirshleifer, Robert Hauswald, Mohsin Khan, Laura Kodres, Ashoka Mody, Peter Montiel, Saleh Nsouli, Mahmood Pradhan, Tony Richards, Ivo Welch, Russ Wermers, Chorng-Huey Wong, and participants at the LSE conference on “Market Rationality and the Valuation of Technology Stocks.” The usual disclaimer applies. Sushil Bikhchandani and Sunil Sharma 280 the fragility of the financial system. 1 This raises questions about why it is surprising that profit-maximizing investors, increasingly with similar information sets, react similarly at more or less the same time? And is such behavior part of market discipline in relatively transparent markets, or is it due to other factors? For an investor to imitate others, she must be aware of and be influenced by others’ actions. Intuitively, an individual can be said to herd if she would have made an investment without knowing other investors’ decisions, but does not make that investment when she finds that others have decided not to do so. Alternatively, she herds when knowledge that others are investing changes her decision from not investing to making the investment. There are several reasons for a profit/utility-maximizing investor to be influ- enced into reversing a planned decision after observing others. First, others may know something about the return on the investment and their actions reveal this information. Second, and this is relevant only for money managers who invest on behalf of others, the incentives provided by the compensation scheme and terms of employment may be such that imitation is rewarded. A third reason for imita- tion is that individuals may have an intrinsic preference for conformity. 2 When investors are influenced by others’ decisions, they may herd on an investment decision that is wrong for all of them. Suppose that 100 investors each have their own assessments, possibly different, about the profitability of investing in an emerging market. For concreteness, suppose that 20 of the investors believe that this investment is worthwhile and the remaining 80 believe that it is not. Every investor knows only her own estimate of the profitability of this invest- ment; she does not know the assessments of others’ or which way a majority of them are leaning. If these investors pooled their knowledge ... amount in IRAs rose from $239 billion in 1992 to $3.7 billion in 2005 to over $5 billion in 2012, as per the 5/11 Intertemporal Choices in Financial Capital Markets Investment Company Institute,... 10/11 Intertemporal Choices in Financial Capital Markets Review Questions According to the model of intertemporal choice, what are the major factors which determine how much saving an individual... since they will treat a loss 8/11 Intertemporal Choices in Financial Capital Markets to their savings account as higher than the benefit of paying off their credit card The dollars are not being