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Economic Review

Economic Review
Fourth Quarter 1997, Volume 82, Number 4

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

Treasury Auctions: What Do the Recent Models and Results Tell Us? Movements in the Term Structure of Interest Rates
Saikat Nandi 4 Robert R. Bliss 16

Auctions, as selling mechanisms, have existed for well over two thousand years. Today, one of the most important auction markets in the world is that of U.S. Treasury securities; approximately $2 trillion worth of Treasury securities was auctioned in 1995.

A long-standing debate has been about selecting an appropriate auction format for various Treasury securities, a format that would be least subject to possible manipulation by individual traders or a cartel and also result in the highest possible revenues for the Treasury. The Treasury is currently experimenting with what is called a uniform-price format for auctioning two- and five-year Treasury notes. A similar mechanism might be put into broader use.

This article explains Treasury auctions in light of recent theoretical research and related empirical evidence. Empirically there seems to be no discernible difference between discriminatory and uniform-price auctions in terms of revenue to the Treasury. The author concludes that the proposal to switch to electronic ascending-price open-outcry auctions with an implied uniform price may be worthy of more consideration.

Bond prices tend to move together. Stocks tend to go their own way. This distinction requires completely different approaches to managing risks for these securities. For equities the emphasis is on reducing idiosyncratic risk through portfolio diversification. For interest rate–sensitive securities it is on precisely balancing a portfolio to achieve the desired exposure to systematic risk factors.

Hedging to reduce or eliminate the common factors influencing an interest rate—sensitive portfolio's value requires a model of interest rate behavior. This article reviews and extends previous studies showing that term structure movements can be decomposed into three components—changes in the general level of interest rates, changes in the slope of the term structure, and changes in the curvature of the term structure. It presents empirical analysis showing that since 1970 the structure of these factors has not changed appreciably even though interest rate volatility has. The author provides a numerical example demonstrating that hedging based on the factor decomposition is superior to hedging based on the traditional method of Macaulay duration.

The Insider Trading Debate Financial Development and Growth
Jie Hu and Thomas H. Noe 34 Zsolt Becsi and Ping Wang 46

Securities trading has generated some of the most sensational scandals in the popular business press. In one of the most publicized cases of insider trading, in the late 1980s Michael R. Milken and Ivan F. Boesky were sentenced to stiff prison terms and payment of enormous damage assessments and punitive penalties. However, at least among economists and legal scholars, insider trading remains a controversial economic transaction. A substantial body of academic and legal scholarship questions whether insider trading is even harmful, much less worthy of legal actions.

The authors of this article explore the sources of the insider trading controversy and suggest a road map for blending the divergent scholarly opinions into a policy framework for regulating insider trading. They conclude that the divergence of opinion can be attributed primarily to disagreement over which effects of insider trading will have the most significant impacts on economic well-being. The voluminous literature suggests that designing effective policy on insider trading requires a detailed assessment of the structure of the economy, some sensitivity to cultural attitudes toward the appropriateness of such trading activity, and careful consideration of the enforcement costs associated with regulating trade.

Poor performance by the financial sector can be costly for society. On the other hand, a healthy banking sector has been thought by some to contribute to the growth of the economy. Recently, though, economists have begun to analyze new elements of the linkages between the financial and real sides of the economy.

This article provides an illustrative model that is meant to capture current thinking about the ways in which financial intermediaries affect growth. The model shows how households, firms, and financial intermediaries interact to determine equilibrium growth rates and various interest rates and rate spreads. It is also used to discuss the effects of repressive financial policies such as reserve requirements, interest rate controls, and entry limitations such as barriers to interstate banking.

The authors survey recent empirical literature on growth and financial intermediation, which has shown that different measures of financial development are positively correlated with economic growth rates. They conclude that although there have been some attempts to quantify the effect of financial repression, attempting precise policy recommendations would be premature.