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[Economics and risk management]
Economics and risk management
An initial field of study for the Economics Research Centre deals with matters of both economics and finance, for one, because the environment for financial decisions is economic and because a firm grasp of the mechanisms that affect this environment will lead to better choices and, for another, because financial tools and practices sometimes shed light on or provide an interesting description of economic problems. One theme involves inflation and the modeling of inflation, a second the pricing and risk measurement of real estate investments, and a third the management of the national debt.
The growing tension in agricultural and industrial commodities markets, tension linked in part to the growth of demand in China and in India and in part to subsidies for bio-fuels, has brought the problems linked to inflation to the fore. Inflation is a significant element in the economic and financial decision-making environment. Difficult to predict, susceptible to factors of varying nature, it affects the present and future allocation decisions of economic agents. Decisions made less efficiently than they would be were information complete have a cost on welfare that is all the greater with increased uncertainty. So understanding and modeling the dynamics of inflation is in issue that remains current, as shown by recent publications (Cecchetti et al. 2007, Mishkin 2007) that have highlighted the importance of basing expectations on credible mechanisms and of the role of monetary authorities. The Centre will do work on inflation modeling. The simplified mechanisms at the source of inflation will be introduced and the influence of each evaluated. The interaction among the prices of certain assets and certain inflation mechanisms can then be studied empirically.
1.2 Real estate
Real estate accounts for the bulk of the wealth of most households. It often takes the form of owner-occupied housing. The European labour market involves more and more personal mobility. As a result, the decision to make a housing investment takes on a greater financial investment aspect. In recent years, the price of real estate in many countries has gone up considerably; this growth has had several causes, with the financial terms offered playing a significant role in the United States. In France, rising real estate markets are the result of, among other things, an increase in the number of households and a small increase in housing stock as well as of the cost of credit and policies linked to local tax structures and assessments. The objective of the Centre is to shed light on some of the mechanisms at work in the formation of real estate prices. Before we undertake this work, however, it will be necessary to study the indices and gauges of performance for this particular asset.
For commercial real estate, the issues, with the exception of the matter of end use, are the same. The price and the return on the asset are at the heart of the investment decision. But gauging returns is complex, as the price of real estate assets, relatively illiquid and subject to high transaction costs, is very sensitive to the conditions of a highly cyclical market. For real estate UCITS, returns are drawn from market prices. There is a body of literature on these matters. For other companies, returns are measured with appraisals, a method whose limitations have been pointed out by many studies. In particular, they are smoothed and make it impossible to construct measures of volatility representative of that of the market. As Fisher et al. (1994) note, the problem stems from the behaviour of appraisers, the frequency of new appraisals, and their aggregation. Several methods of reconstructing the underlying return measures have been suggested (assuming that the market is efficient or using a model of behaviour of appraisers with little confidence in the reliability of their appraisals and smoothing the results with old information, or even combining these two assumptions [Geltner 1993, Bond and Hwang 2003]). These proposals have been the object of few critical analyses (Lai and Wang 1998). It should be noted, nonetheless, that in these approaches the very nature of the assets is rarely taken into account. The goal of the Centre is to study these matters and to devise a more representative measure of return and risk premia for this type of investment.
1.3 Optimal management of the national debt
This programme involves both normative and positive lines of research. The normative lines have to do with the development of tools for the study of the optimal asset/liability management of a sovereign state. Initially, we will study the optimal composition of the debt in terms of media (nominal bonds, indexed bonds, and so on) and of maturity for a treasury at the service of a government that must manage sovereign missions and wants to put in place a policy of redistribution. This corresponds to an extension of the standard model for asset allocation to liability allocation. This work done by the EDHEC Risk and Asset Management Research Centre in the private sector takes on a different nature as a result of the particular features of a national government. So, for example, the notion of collateral is relevant to private enterprise but not to the government, default risk no longer takes the same form, and analysis in the context of a partial equilibrium for a company must be approached in a broader context and taking into account the strategic weight of the state.
After we study the problem from a point of view limited to liability management, an extension that takes into account the effect on optimal debt composition of changes in risk linked to government assets should enrich the analysis. It is a matter of formalising intuitions that are at the source of debt composition choices. For example, issuing inflation-indexed bonds, which, as a result of the uncertainty as to future rates of inflation, leads to greater risk from a liability management point of view, no longer seems necessarily to bring with it increased uncertainty as to financing needs when asset flows naturally affected by inflation are taken into account. By contrast, if inflation and government spending increase in harmony, issuing nominal bonds can reduce the real cost of financing.