Second Annual Conference
Conference Report
(By Yanfang Yan)
The Second Annual Conference of the Chinese Finance Association (the
CFA) was held at the Charles Hotel in Boston, Massachusetts September 23-24,
1995. Nearly 70 CFA members and guests attended this annual event.
The meeting commenced with a welcome speech by Mr. Hongbin Cai of
Stanford University, President of the CFA. A special presentation session
followed the opening speech, with a focus on the practical areas of the
Finance. Mr. Mark Kritzman, founding partner of Windham Capital Management,
presented his research on Multi-Risk Asset Allocation. A prominent
quantitative analyst and associate editor of Journal of Derivatives, Mr.
Kritzman proposed a simple while effective approach to handle concerns about
risks other than the traditional variances. Next, Mr. Joe Langsam, Principal
and Head of Fixed Income Research of Morgan Stanley & Co., shared with the
audience his rich experience and insights about the emerging markets. He also
summarized the characteristics of the emerging markets, including the Chinese
markets, and discussed some interesting research topics. CFA member Ms. Yan
Wang is an economist of the World Bank. She presented her recent research
about China's foreign investment, which made a detailed analysis of the recent
trend of foreign direct investment in China, and its correlation with and
impact on China's macroeconomic situation. She also proposed policy
suggestions to the Chinese government. Her speech generated wide interests
and provoked a heated discussion among the audience.
After the conference lunch, Professor Merton Miller, a Nobel Laureate
from the University of Chicago, delivered the keynote speech entitled "The
Chinese Economic Growth: The Next Fifty Years." Famous for his pioneering
work in corporate finance and his insights in financial market development,
Dr. Miller compared economic development of Mainland China and Taiwan. He
analyzed various factors that will help or hamper Mainland China’s bid to
achieve in the next fifty years the growth rate that Taiwan has achieved in
the last fifty years. After the speech, Professor Miller answered many
questions from the audience.
The meeting continued in the afternoon with a Mini-Conference consisted
of presentations by three distinguished speakers. Professor John Campbell of
Harvard University gave a presentation on "Consumption and International Stock
Market," while his colleague Professor Oliver Hart’s topic is "Incomplete
Contract, Financial Contracting, and Bankruptcy Reform." The third speaker is
Professor Franco Modigliani of Massachusetts Institute of Technology. The
famous Nobel Laureate presented his research entitled "The Chinese Saving
Puzzle and the Life Cycle Hypothesis."
The meeting concluded its first day with the conference dinner. Before
the dinner, Mr. Hong Yan, editor of the CFA Update, an official newsletter of
the Chinese Finance Association, newsletter, conducted a special presentation
about the newsletter, a major success of the organization. Mr. Yan reviewed
the creation of the newsletter, descried its impact on the organization, and
encouraged active participation from CFA members.
The second day of the meeting started with a lively discussion between
meeting participants and Mr. Chifu Huang, an economist from Long Term Capital
Management. Dr. Huang was professor of MIT and Head of Fixed Income Research
at Goldman Sachs before joining the famous Long Term Capital. His discussion
topics covered various issues in current research in finance and future
directions.
The conference followed by paper presentations. Four members presented
their research papers on various topics. Professor H. Henry Cao of the
University of California at Berkeley presented his paper "Imperfect
Competition in Securities Markets with Diversely Informed Traders," with a
discussion by Mr. Hong Yan from the same school. Professor Liang Zou of the
University of Amsterdam, with co-author Mr. Laixiang Sun of the Institute of
Social Studies at Netherlands, presented their paper "Some Justifications for
the Low Interest Rate Policy in the Transitional China," and followed by
discussant Mr. Bo Li of Stanford University. Dr. Chunsheng Zhou, economist
from the Federal Reserve Board then introduced his model on "Forecasting Stock
Returns and Stock Prices," followed by discussant Mr. Xiaodi Sun of
University of Chicago. The session concluded with Mr. Ming Huang's
presentation on "Swap Rates and Credit Quality," co-authored with Professor
Darrell Duffie. Both the two authors and the discussant Mr. Qiang Dai are
from Stanford University.
The conference resumed in the afternoon, with a discussion by Dr. Ping
Jiang of Lehman Brothers on "Opportunities with Investment Banks for CFA
Members." Informal job interviews with interested participants followed.
The Closing Remarks were given by Mr. Qiang Dai, Chairman of the Board
of the CFA. He thanked the meeting preparatory committee and others for
making the meeting a very successful one. The board members were also invited
to give brief reports of their activities for the year.
The meeting ended with an election of officers and a revision of the
association by-laws. Members who attended the meeting elected the following
new officers of the CFA for the year 1995-1996:
President: Sun, Xiaodi Steve (University of Chicago)
President-elect: Li, Bo (Stanford University)
The President and President-elect are automatically Board members of the
the CFA, according to the CFA Bylaw. The other seven members of the CFA Board
of Directors are:
Jiang, Ping (Lehman Brothers)
Liu, Zheng (University of Minnesota)
Ma, Qing (Cornell University)
Ma, Xianghai (Boston University)
Wu, Guojun (Stanford University)
Wu, Qianli (Boston University)
Yan, Hong (UC Berkeley)
Guojun Wu was elected by the directors as the Chairman of the Board.
Featured Speakers
Prof. John Campbell Harvard University
Prof. Oliver Hart Harvard University
Dr. Chi-Fu Huang Long Term Capital Management
Mr. Mark Kritzman Founding partner, Windham Capital Management
Dr. Joe Langsam Principal and Head of the Fixed Income
Research, Morgan Stanley
Prof. Merton H. Miller Nobel Economics Laureate, University of Chicago
Prof. Franco Modigliani Nobel Economics Laureate, MIT
Dr. Yan Wang Economist, World Bank
Summaries of Selected Presentations
(By Yan, Yanfang)
1. Chinese Economic Growth: The Next 50 Years (Keynote Speech)
Speaker: Merton H. Miller, University of Chicago
2. The Chinese Savings Puzzle and the Life Cycle Hypothesis
Presented by Franco Modigliani, MIT
(Co-Author: Larry Shi Cao, Harvard University)
3. China's Foreign Direct Investment
Presented by Yan Wang, the World Bank
4. Risk Management in Emerging Markets
Presented by Joe Langsam, Morgan Stanley
5. Multi-Risk Asset Allocation
Presented by Mark Kritzman, Windham Capital Management
6. Consumption and International Stock market
Presented by John Campbell, Harvard University
7. Incomplete Contract, Financial Contracting, and Bankruptcy Reform
Presented by Oliver Hart, Harvard University
8. Imperfect Competition in Securities Markets with Diversely Informed Traders
Presented by H. Henry Cao, UC Berkeley
9. Forecasting Stock Returns and Stock Prices
Presented by Chunsheng Zhou, Federal Reserve Board
10. Swap Rates and Credit Quality
Presented by Ming Huang, Stanford University
(Co-Author: Darrell Duffie, Stanford University)
11. Interest Rate Policy and SOE Incentives in the Transitional China
Presented by Liang Zou, University of Amsterdam
(Co-Author: Laixiang Sun, Institute of Social Studies at Hague, The
Netherlands)
Choose:
1 2 3 4 5
6 7 8 9 10
11
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1. Chinese Economic Growth: The Next 50 Years (Keynote Speech)
Speaker: Merton H. Miller
Comparing the economic development of Mainland China and Taiwan,
Professor Miller is optimistic about China's economic growth. He
attributed his optimism to common pattern of cultural and family values
shared by Taiwan and the Mainland China. The stress on family values
contributes to economic growth in many ways. First, Chinese families,
even with modest incomes, are prepared to make big investments in the
human capital by pressing and financing their children for academic and
professional achievement. Both the private and social payoffs on this
kind of investments are high. Second, in addition to investment in human
capital, the Chinese families also contribute to the accumulation of
financial capital by maintaining a high savings ratio. Nature has been
kind to countries striving to grow: they must use savings to grow, but
growth does not use it up. Successful growth creates more savings for
further growth in a virtuous circle, as opposed to a vicious circle.
Prof. Miller also pointed out that to invest society's savings
efficiently requires entrepreneurship and here again the Chinese human and
cultural pool is well provided, as demonstrated not only in Mainland
China, Taiwan and Hong Kong, but also in such nominally non-Chinese
countries as Thailand, Vietnam, Singapore and Indonesia. Also, the family
business ties of the overseas Chinese will help to bring into China
enormous foreign investment. While the big-name US firms get most of the
publicity about investing in China, the real foreign investment story is
the thousands of small and medium-sized factories set up and managed by
overseas Chinese.
It is not realistic, however, to expect China over the next 50
years to reach the standard of living that Taiwan enjoys today after its
last 50 years, Dr. Miller argued. Lack of stable monetary institutions
and developed financial markets limits the country's capability to bring
down price inflation and stabilize its domestic money supply. Reform of
the state-owned enterprises is another difficult task the Chinese
government faces. These "factory complexes" provide their labor force
with schools, hospitals, roads, housing, utilities and virtually every
other social amenity. For those great, hulking iron rice bowls, Mr.
Miller pointed out, the urgent need in the short run is actually the
opposite of privatization. Responsibility for the safety net and for the
civil services must be transferred away from conglomerates and back to the
public sector. Otherwise, rational economic calculations in the business
sectors of the enterprises become impossible.
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2. The Chinese Savings Puzzle and the Life Cycle Hypothesis
Presented by Franco Modigliani, MIT
(Co-Author: Larry Shi Cao, Harvard University)
China's household savings ratio has reached a sky-high level
during recent years while there has been a world-wide reduction in private
savings ratios. In 1993, for example, the estimated Chinese household
savings ratio stood around 23%, exceeding by a large margin over the
Japanese experience in the 1960s. At the same time, however, the level of
China's income per capita remained well below those of the industrialized
nations. More surprisingly, looking back at the postwar history of
Chinese household savings, one finds that the "thrifty" Chinese were not at
all high savers from the 50s through the mid-70s, with an average
household savings ratio below 4%.
This paper attempts to reconcile this puzzling "contradictions" in
the framework of the Life-Cycle Hypothesis (LCH) developed by Modigliani,
Brumburg, and Ando. The LCH was intended, at least in the early stage, to
be applied to the developed market economies only. China is a developing
country having undergone regime shifts from a highly planned economy to a
market-oriented eocnomy. Therefore, application of the LCH in China's
context not only offers an empirically plausible explanation to the
puzzle, but also provides theoretical implications as to the extension of
the applicability of the LCH to a much more general environment.
Empirical results using Koyck estimates and Almon estimates
indicate that growth rate and demographic condition are two important
factors that may accout for the spurt in Chinese savings in the last two
decades. As it is generally believed, however, that the traditional
keynesian theory may play an important part in explaning the savings
behavior of the low-income nations, the paper also includes a comparison
of the results of the LCH and the Keynesian model. Results indicate that
the former provides a better quality of fitted value than the latter.
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3. China's Foreign Direct Investment
Presented by Yan Wang, the World Bank
China's capital market has been developing rapidly from
essentially nothing as the country has embarked on rapid market reforms.
China's opening up and integration into the international capital market
has attempted to follow orderly, natural and sequential steps: official
borrowing first, private foreign direct investment (FDI) second, and
private portfolio investment last. However, so far its markets are still
fragmented, and the development of these markets far from complete.
The Chinese government entered the international capital market
through commercial bank borrowing and issuing of international bonds in
the late 1970s. Official borrowing totaled US$10.6 billion during 1979-82
and continued to increase throughout the 1980s. In the first stage of
domestic capital market development (1981-1990), the governemnt issued
bonds and corporations issued stocks only to domestic investors. These
were essentially to mobilize saving. Although the total amount of
securities issued reached over 175 billion yuan by the end of 1990, a
formal secondary market could not develop due to the absence of an
adequate legal framework and institutional infrastructure.
In the real sector, however, investment climate was greatly
improved. Governments at all levels attempted to attract FDI through
favorable tax concessions and tariff exemptions, and by creating various
special economic development zones with more flexible policies towards
FDI. Most FDI was in the form of joint ventures. FDI inflow increased
gradually from $.6 billion in 1983 to US$4.4 billion in 1991, and then
rose dramatically to reach $23 billion in 1993, and nearly $30 billion in
1994.
Using an endogenous growth model and provincial data, the author
shows that FDI not only becomes an important source of external financing,
but also promotes productivity growth. Preliminary empirical analysis
also shows that shares of Chinese state owned enterprises have a negative
effect on growth rates.
The author further states that China will not likeley suffer from
the same type of risk such as the Mexican Crisis at this stage. This is
because that the capital flow's compositions are different between the two
countries. Short term and portfolio flows are the main source of capital
inflows in Mexico while FDI dominates in China. In addition, savings had
been declining in Mexico and capital flow had been used to support an
overvalued currency for too long. However, the author points out that
China faces the same challenge on how to manage capital flow and its macro
impact.
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4. Risk Management in Emerging Markets
Presented by Joe Langsam, Morgan Stanley
Investment banks face a myriad of risks. The key to risk
management is to reduce noncompensated risk. The very first line of
defense against risk is proper recruitment and personnel management.
Recruit individuals with integrity, drive, and intelligence and reward
these merits. The first requisite for risk management is good data, both
of position and of market. A new investment bank has the opportunity to
design its infrastructure to make this data collection and risk monitoring
an integral part of doing business. Risk management requires knowledge of
financial theory and reality of the market, it also requires good business
peripheral vision. Good reputation plays an indispensible role for
investment banks. Therefore to be truly effective, risk management needs
to be visible both internally and externally. The products of risk
management are not merely protection from catastrophic losses, but also
increased business opportunities and cheaper cost of capital.
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5. Multi-Risk Asset Allocation
Presented by Mark Kritzman, Windham Capital Management
Portfolio managers often need to evaluate simultaneously two
dimensions of asset risk: absolute and relative risk. Traditional asset
allocation such as mean-variance and mean-tracking error optimization,
however, typically considers them independently in the optimization
process.
The absolute risk is measured as the variability of a portfolio's
total return, and relative risk is measured as a portfolio's tracking
error relative to a prespecified benchmark. This benchmark can be defined
in a variety of ways including a composite portfolio of competing funds, a
policy portfolio, a specific asset, or a pool of pension liabilities.
The goal of mean-variance optimazation is to identify portfolios
that offer the highest expected return for varying levels of risk measured
as standard deviation or its squared value, variance. It ignores investor
concerns about deviating from a benchmark or the normal asset mix of
competing funds. The typical solution to this limitation is to impose
constraints on the allocation of the portfolio to particular asset
classes.
The goal of mean-tracking error optimization is to identify
portfolios that offer the highest level of expected return for varying
levels of tracking error. Tracking error is a measure of relative risk;
that is, variability around a benchmark's performance. It is equal to the
square root of the average of the squared differences between a
portfolio's return and a benchmark's return. This type of asset
allocation ignores investor concerns about failing to achieve a positive
real rate of return or falling short of an alternative absolute target.
The typical solution is to resort to mean-variance asset allocation and to
impose allocation constraints to address relative performance.
A more efficient solution is to incorporate both absolute
volatility and tracking error simultaneously in the optimization process.
This paper proposes mean-variance-tracking-error asset allocation which
incorporates both standard deviation and tracking error as risk parameters
in the optimization process. The evaluation of portfolios, therefore,
simultaneously addresses both absolute risk and relative risk. Rather
than producing an efficient frontier in dimensions of expected return and
standard deviation or expected return and tracking error, this approach
produces an efficient surface in all three dimensions, i.e., of expected
return, standard deviation, and tracking error.
This multi-risk framework allows the investor to evaluate
portfolio choices based on their probability of simultaneously failing to
achieve the absolute and relative targets. It also allows the investor to
measure the rate of substitution between standard deviation and tracking
error for portfolios with the same expected return.
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6. Consumption and International Stock market
Presented by John Campbell, Harvard University
During the past 15 years, the behavior of aggregate stock prices
has been one of the most intensively studied topics in economics.
Researchers, working primarily with US data, have documented a host of
interesting stylized facts about the stock market and its relation to
short-term interest rates and aggregate consumption. These facts give
rise to two puzzles: the equity premium puzzle, first introduced by Mehra
and Prescott in 1985, and the stock market volatility puzzle, discussed by
LeRoy and Porter in 1981. The first puzzle refers to the fact that the
stock return is high in relation to the average return on short-term debt.
The second points out that the plausible measures of expected future
dividends are far less volatile than real stock prices.
These two puzzle are closely related. A complete model of stock
market behavior must explain both the average level of stock prices and
their movements over time. Unfortunately, it is not easy to construct a
model that fits all the stylized facts documented. In the standard model
of Hansen and Singleton(1983) and Mehra and Prescott (1985), which equates
consumption and dividends, there is no predictable variation in excess
stock returns. To get predictable variation in excess stock returns, many
researchers have explored the idea that the quantity of stock market risk
varies over time. But there is little evidence of cyclical variation in
consumption or dividend volatility that could drive the variation in stock
return volatility. The author argues that to make sense of stock market
behavior one needs a model in which investors' risk aversion is both high
and varying, such as the external habit-formation model of Campbell and
Cochrane (1995). Data from other countries are examined to see which
features of the US experience apply more generally.
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7. Incomplete Contract, Financial Contracting, and Bankruptcy Reform
Presented by Oliver Hart, Harvard University
Incomplete contracts and allocation of control power can help us
understand institutions and institutional design. They offer us insight
into aspects of institutions that the neoclassical and agency approaches
fail to provide. In particular, the study of incomplete contracts sheds
light on the nature of asset ownership, boundaries of firms, financial
structure of firms, and issues such as bankruptcy procedure and
privatization etc..
Consider a situation in which an entrepreneur wishes to raise
funds to undertake a project when contracting possibilities are
incomplete. Both the entrepreneur and the outside capitalists can observe
the project payoffs but the third parties, such as the courts, cannot
observe them. This creates an incentive problem for the entrepreneur to
repay the loan. Although the creditors can seize proportion of assets and
liquidate them if the entrepreneur defaults, liquidation is ex-post
socially inefficient, because the liquidation value is less than the
present value of the next period payoffs. It is shown that a debt contract
is an optimal solution and the incentives to repay are provided by the
threat of liquidation. Inefficiencies may also be reduced through the use
of short-term or long-term debt depending on when information arrives and
the pattern of payoffs. The incomplete contracts in this case offers
rationale for the use of debt and equity for closely held firms.
Incomplete contracts can also explain the role of takeovers and
securities voting structure for widely held firms where a free-rider
problem exists. For example, it can be shown that the widespread use of
one share, one vote among publicly owned firms is optimal when there is
asymmetric private benefits of control between the incumbent management
and the rivals. In providing a theory of institutions, the incomplete
contracts approach not only captures incentive problems but also
emphasizes the importance of residual control rights over nonhuman assets
and the boundaries of firms. It further gives guidance to good bankruptcy
procedure, i.e., expost efficiency and adequate penalty for manager.
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8. Imperfect Competition in Securities Markets with Diversely Informed Traders
Presented by H. Henry Cao, UC Berkeley
We show that the infinite regression problem in models with
differentially informed traders can be solved using a fixed point method
which we use to derive the dynamic equilibrium in a multi-auction model
with diversely informed traders. We find that when the informed traders'
signals are not perfectly correlated, their private information will be
revealed to the market gradually so that the market is only semi-strong
form efficient and not strong-form efficient. Market depth in the
continuous auction model initially increases with time but decreases to
zero at the end. Our results are in contrast to the results of Holden and
Subrahmanyam (1992) and Forster and Viswanathan (1993) (HS-FV) who showed
that when auctions occur frequently and informed traders have perfect
information, the information is revealed to the market almost immediately.
However, when the correlation in the private signals goes to 1, our model
converges to the HS-FV model.
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9. Forecasting Stock Returns and Stock Prices
Presented by Chunsheng Zhou, Federal Reserve Board
There is now considerable evidence that documents the
predictability of financial asset returns. Several models have been
popular in the literature to characterize this kind of predictability.
This paper evaluates these models by a Kalman Filter technique and finds
some serious flaws of these models. The paper then proposes a parsimonious
state-price model with two state variables to characterize stochastic
movements of stock returns. Using equal-weighted CRSP monthly returns, the
paper shows that (1) this model captures the autocorrelations of returns
excellently over both short and long horizons; (2) although the forecasts
obtained with the state-space model based solely on past returns, they
subsume the information in other potential predictor variables such as
dividend yields; (3) the model not only has very strong power to predict
long-horizon returns, but also predicts the short-horizon returns much
better than most other models do; and (4) the extracted expected returns
can explain a substantial proportion of the variation in realized returns.
At a horizon of 5 years, the proportion can be as high as 50 percent.
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10. Swap Rates and Credit Quality
Presented by Ming Huang, Stanford University
(Co-Author: Darrell Duffie, Stanford University)
The impact of credit quality on swap rates or forward prices is
determined under alternative netting assumptions. With counterparties of
different defaut risk, swap valuation is non-linear in the underlying
promised exchange of cash flows. The impact of credit risk asymmetry and
of netting is presented through both theory and numerical examples, which
include interest rate and currency swaps.
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11. Interest Rate Policy and SOE Incentives in the Transitional China
Presented by Liang Zou, University of Amsterdam
(Co-Author: Laixiang Sun, Institute of Social Studies at Hague, The
Netherlands)
Despite many criticisms and high inflation expectations, China has
maintained a low interest rate policy since the beginning of her economic
reform. Reasons for this persistent underpricing of credit have not yet
been fully understood. In this paper we present a formal model that
incorporates the notion that the state-owned enterprises (SOE) are able to
influence not only the return, but also the risk, of their investments. In
this two-dimensional moral hazard model, we investigate the SOEs' optimal
choices of effort and risk, and how they might be affected by changes in
interest rates, taxes and the firms' self-financing. Our results suggest
that there are solid incentive-based reasons for the low interest rate
policy in China.