No one questions any longer the fact that we are facing the greatest international financial crisis since the Great Depression. Since September 2008, the world has seen unprecedented events that are re-shaping the international financial system and challenging liberal economic orthodoxy, which had gone practically unquestioned since the 1990s under US leadership. The sub-prime mortgage crisis that erupted in August 2007 has become a systemic financial crisis whose epicentre is no longer just in the US, but rather has spread to Europe and Japan and is having a powerful impact on the growth of the emerging economies.
Investment banks have vanished, and governments have redefined the role of lender of last resort, launching rescue packages on both sides of the Atlantic, first for specific financial institutions and then for the banking system as a whole. The G7 says it will use all means at its disposal to support financial institutions that need help, but the pledge lacks credibility because the group failed to present a coordinated plan. The US Congress, in its second attempt, approved a bail-out plan, called the ‘Troubled Asset Relief Program’ (TARP), a US$700 billion package that in the end will earmark US$250 billion for injecting funds to recapitalise the banking industry –and partially nationalise it–, something many Republicans do not approve of (the rest of the money will go towards buying up toxic assets). The UK, in a rare display of leadership, has nationalised part of its banking system and will back up inter-bank loans. The countries of the euro zone will follow the British model, although each country has set aside a different amount of money to buy preferential shares in undercapitalised banks or help them with their short-term financing problems (the funds made available for tackling the crisis in Europe exceed €2.5 trillion).
The state of practice of assessing the financial impact of jumps in market variables on derivative positions is far from ideal: (1) the mechanics of theoretical perfect replication that are the foundation of pricing models for derivatives are challenged in the face of jumps of random magnitude and uncertain timing, let alone practical difficulties with replication; (2) many pricing models in practice are continuous-diffusion process based and do not entertain jumps (see Cont & Tankov [2004] for an overview). Controlling the risk profile of derivative trading, however, requires understanding P&L impacts due to realistic changes in pricing input variables, which can involve sudden moves not captured by diffusive processes. Furthermore, managing a derivative trading book requires understanding and anticipating the impact of jumps in basic market variables on more exotic pricing model inputs.
A growing theoretical literature has focused attention on the impact of risk on investment, and has suggested that the impact may be large. The reason is that most investment expenditures are at least in part irreversible - sunk costs that cannot be recovered if market conditions turn out to be worse than expected. In addition, firms usually have some leeway over the timing of their investments they can delay committing resources until new information arrives. When investments are irreversible and can be delayed, they become very sensitive to uncertainty over future payoffs. For example, in a simple and fundamental model of irreversible investment, McDonald and Siegel (1986) demonstrated that moderate amounts of uncertainty consistent with many large industrial projects could more than double the required rate of return for investments. Hence changing economic conditions that affect the perceived riskiness of future cash flows can have a large impact on investment decisions, larger than, say, a change in interest rates.
This theoretical literature and the insight it provides may help to explain why neoclassical investment theory has so far failed to provide good empirical models of investment behavior, and has led to overly optimistic forecasts of effectiveness of interest rate and tax policies in stimulating investment.' It may also help to explain why the actual investment behavior of firms differs from the received wisdom taught in business schools. Observers of business practice find that the "hurdle rates" that firms require for expected returns on projects are typically three or four times the cost of capital. In other words, firms do not invest until price rises substantially above long-run average cost.
