Financial Market History PDF

Book 1 : Financial Market History by Chambers and Dimson 1) Describe long-run asset returns and their order of magnitude (chapter 1) Cumulative real return : Returns include reinvested income, are measured in local currency, and are adjusted for inflation. - Performance of asset cl...

Book 1 : Financial Market History by Chambers and Dimson 1) Describe long-run asset returns and their order of magnitude (chapter 1) Cumulative real return : Returns include reinvested income, are measured in local currency, and are adjusted for inflation. - Performance of asset classes : Equities > Government bond > T-bill. In USA, your initial investment would have grown faster than other countries. - Risk of asset classes : Equities > Government bond > T-bill - Inflation was a major force in the 20th century but in mid-1990 there was also mild deflation in few countries. - Treasury bill provide a benchmark for the risk-free rate of interest. There were negative real returns on bill in several countries. Inflation kills real returns. - Exchange rate : Currency linked to the price of gold foreign exchange risk is unimportant. High inflation in country implies a weakening of local currency against foreign currency. Most currencies weakened against US dollar except Swiss franc. - The real exchange rate = nominal exchange rate * ratio of 2 countries inflation indices. These real exchange rates don’t appear to exhibit a long-term upward or downward trend but are clearly volatile. - Cross-border investment : Each investor has 2 exposures ; foreign equities and foreign currency. - Overall return : ROverall = (1 + REquity)(1 + RCurrency) – 1 In long-term, the cross section of stock market returns reflects differing real equity performances far more than differing real exchange rates. 2) Discuss the time-variation of expected returns and the challenges of timing the market (chapter 2) : 1  - Bond investors estimate long-run returns almost always start from market yields. Equity investors assumed expected returns are constant over time, so they don’t start from (dividend) yield when assessing long-run expected returns. - When assuming constant expected returns, best forecast is simply the historical average. Long sample periods give better estimates because they mitigate sampling variation in returns, assuming that there are no structural/regime changes. - CAPM model, random walk model, efficient market hypothesis, we have a constant E(R) - Market timing had developed a bad name among practitioners. These market timing strategies become popular after market crashes. P/E and dividend yield are valuation-based indicators to measure market conditions and timing signals. There are also value and momentum as timing indicators disappointing out-sample performance. - Over long horizon, value and yield indicators tend to have the best predictive ability. Over short horizons, momentum and macro indicators are more helpful. - Investors should exploit all knowledge about historical experience, theories, and current market yields/valuations without depending on them. Time Variation in E(R) Explanation (two points of view) : - Rational explanations : include time-varying volatility, time-varying risk aversion and time-varying risk of rare disasters. These explanations are mainly cyclical. - Irrational explanations : rely on time-varying investor sentiment, cycles of greed and fear social interactions. Combine macroeconomic variables and timing indicator to forecast the predictable part of equity returns. The best thing to do is to be well-diversified to earn consistent long- term returns, exposed across many rewarded factors. 3) Discuss the challenges and biases of financial market databases (chapter 3) Easy data bias : It’s the most pervasive problem in existing long-run financial data. These easily available historical sources omit troubled periods from analysis. Some historical sources are often hidden in archives and difficult to access. This increases the 2 cost of data collection and that’s why we use a secondary sources aka ‘’ second best” which summarize the data without explicitly stating the methodology. Indeed, the troubled periods as wars, radical changes in economic regimes are omitted. First, these sources are rare and difficult to interpret during these periods. Secondly, institutional changes require effort to make data coherent with previous ones. Third, markets are closed during these periods (e.g., The Lisbon exchange was closed 3 years (carnation Revolution 1974-1977)). Selection bias : It’s a corruption of statistical analysis resulting from the sampling process. The tendency to focus only on larger companies may lead to under-estimated returns as analysts miss the higher returns offered by firms with low market value. Moreover, the selection of value stocks with high fundamentals-to-price ratios can also significantly alter returns. Survivorship bias : It concerns both companies and markets. The tendency is to consider only the securities of issuers that survived up to the end of the period studied. We have to include these delisted securities because your investment strategies can lead to optimistic results. Weighting bias : Indices are not necessarily representative of the investable universe. The market capitalization is not easily available, so we use equal or price weights indices (big difference). Non-synchronous trading effect : First occurs within a single market. This effect creates a non-negligible bias in the moments and co-moments of returns. The second effect arises when the relationship among several markets is examined. Indeed, markets are located in different time zones and markets are often closed because of different national and religious holidays. Stock indices : - Issues with prices, dividends, capital operations, exchange rates, number of shares - Outstanding, inflation can influence calculations. Stock prices can be quoted as % profits or % losses. Moreover, stocks can be simultaneously quoted in different currencies. - The availability of dividends is more problematic than prices. Indeed, the dividends are important to compute the total return which depends on dividend income rather than capital gains. In past period, an average dividend yield was computed using only dividend-paying shares, biasing the dividend yield estimate upward (many companies 3  did not pay dividends). Dividend can be net or gross and are added to the return which will create volatility and seasonality. - The availability of information on securities events, such as (reverse) stock splits, inscription right and bonus rights. It’s difficult to identify these events. - The types of stock are divided into two categories with different characteristics : common stocks and preferred stocks. Bond indices : - Issuer means government bond and corporate bonds. Government bond has lower yields than corporate bonds but occasionally these latter are traded “through” (at lower yields). - Maturity is an important characteristic. High maturity implies often high yield. - Coupon payment are paid by bonds but there exists zero-coupon bond. They are either fixed or floating. - Liquidity bond is more important than in stock market. Indeed, some bonds are held to maturity and are not available for trading. Moreover, bonds are traded more likely to be traded in OTC (Over-the-counter markets) than stocks. - Bond indices are derived from yield series, this reduces the archival workload and the stale price issue but at a potential cost. - Yield series are often provided from secondary sources. Yields are not perfectly correlated and not constant over time. Yields are computed from the issue’s characteristic and bond price. This latter is either the dirty price or clean price : the first price includes accrued interest. Yield recorded may fail to capture the investment experience of the average bond investor. - The duration approximation involves : yt Dt R T+1 = ( ) − ( ) (yt+1 − yt ) 12 yt - Bond returns can be reconstructed as long as the term to maturity of the proxy does not deviate too much from the market. 4 4) Discuss carry and momentum strategies in the foreign exchange market (chapter 4) - High turnover per day. Very difficult to predict and make money because of poor performance of macroeconomic models. Gains result more from luck rather than skill. Transactions costs depends on the bid-ask spread. - Derivatives are now the most actively traded currency instruments (swap, options). Zero-investment speculation strategies : carry trade, momentum, and value. - Uncovered interest rate parity : High interest rate currencies depreciate on average relative to low interest rate at a rate that eliminates the interest rate differential. - Carry trade strategy : Borrow in low interest currency and invest in high interest currency (called uncovered interest arbitrage). This strategy yields high excess return and high Sharpe ratio. This return to the carry trade should compensate for taking risk of incurring significant losses in bad times. This strategy is exposed to rare disaster or crash risk. Moreover, this strategy performs poorly in times of unexpectedly high global equity market volatility, unexpectedly high global foreign exchange volatility and when liquidity of the foreign exchange market is deteriorated. - Momentum strategy : Borrow in currency with low recent returns and invest in currency with high recent returns. This strategy provides high returns when implemented on a wide range of developed and emerging countries’ currencies. Its performance varies over time and this strategy seems to be unattractive in short- term horizons. These technical strategies performed strongly during interwar period but incurred huge losses in certain months. - Value strategy : Borrow in overvalued currencies and invest in undervalued ones. Covered interest rate parity : If it holds, the forward discount of one currency against another is equal to the interest rate differential between the two currencies. 5) Discuss long-term real estate returns (chapter 5) Real estate is the most important component in portfolio. Real estate has imperfect correlations with financial assets, it’s good for diversification. It’s difficult to make expectations on the financial returns of these durable assets because the risk exposure is hard to estimate. Real assets are indivisible (less diversification), illiquid and costly to maintain/insure. 5  Comparing the investment performance of housing, land, and T-bills, we conclude that the long-term appreciation rates of housing/land have been quite low and equal to the historical returns of T-bills. In other words, real estate returns have historically co-moved with equity, bond returns and inflation. In real terms, housing lose/gain value in the 20th century. This return mainly comes from capital gains. Depending on the location, the return on real estate vary (e.g., rural areas VS superstar cities). However, the housing rental income yield vary over time as well. We should not forget some costs as maintenance costs and so on which reduce the rental yield. 6) Discuss bubble investing (chapter 9) Large price decline after a large price increase (i.e., crash after a boom). A boom does increase the probability of a crash (i.e., mean reversion). These bubbles have low frequency and are conditional to a market boom. Bubbles may take some time to deflate. Bubbles are dangerous for the individual and the economy as a whole because market prices of assets no longer reflect their fundamental value. Households will consume more and borrow more under the bubble-induced illusion that they are wealthier. Problems of a collapsing bubble are amplified if the owners of the asset booms are highly leveraged. Therefore, it remains difficult to determine with any precision how much asset prices may rise or when they may collapse. We can define a bubble in two ways : - A drop of at least 50% in market over the following year. - A drop of at least 50% in market over 5 years. - A high P/E ratio is a good bubble indicator. We can define booms in two ways : - In a single year in which a market value/cumulative returns increased by at least 100%. - A period of three years over which the market increased by 100%. 6 There was different stock market bubble in different country (e.g., in France with Mississippi Company by John Law). Some was interconnected (e.g., Dutch & British bubbles). Some bubbles were related to technological innovation/financial innovation and high productivity. People were very optimistic on valuations. Investing during a bubble depends on gaining cautionary insights to avoid being overwhelmed by irrational exuberance. 7 Book 3 : When Genius Failed by Lowenstein 1) Describe in general terms the investment strategies of Long-Term Capital Management (LTCM) and its use of leverage LTCM focused on bond trading. The trading strategy of the fund was to make convergence trades, which involves taking advantage of arbitrage between securities where maturity was specified, meaning the convergence appeared to be a sure thing. They were buying and selling bonds to bet on the spread. Their models predicted that the spread between two bond yields were too wide for no reason (risk of Italy defaulting overestimated and thus, yields too high compared to Germany bond yield). Hence, the strategy was to bet on a tightening of the yield spreads by buying the higher yield bond and selling the lower yield bond. Indeed, the yield is inversely related to the bond price. Furthermore, LTCM also began to use options (derivatives) to short-sell large amounts of equity volatility, based on its models’ predictions that markets would get more efficient, smoother, and less volatile over time. Due to the small spread in arbitrage opportunities, LTCM has to leverage itself to make money. Therefore, LTCM massively levered itself to collect the gains it made on each basis point movement, multiplied by the amount it was able to implement such a strategy thanks to the leverage. However, this level of leverage also implies a multiplication potential of losses. 2) Describe how LTCM losses started and quickly grew, with increasing credit spreads and volatility Due to the default declaration of Russia, various emerging markets weakened, and investors were running away from investment risk in general wherever it lurked. As a result, spreads (basic thermometers of credit risk) rose unexpectedly high as well as volatility. As LTCM was betting on a tightening of spreads and lower volatility, each basis point widening movement and increase in volatility implied for LTCM massive losses due to their high level of leverage. 3) Discuss Describe why LTCM could not manage to find additional capital The main reason why LTCM was unable to find additional capital has been the lack of transparency from LTCM. Investors were given no information on the health of the fund and how the money was managed over at the LTCM hedge fund. Moreover, the time 1  was at worst to find extra capital since financial market were suffering a market meltdown. Banks tightened credit terms for all hedge funds, forcing them to sell to raise cash. 4) Describe how the fact that LTCM trading positions became known in the market hurt LTCM As LTCM tried to raise capital, its strategies had been exposed and therefore, banks and brokerages were fleeing any position they shared with Long Term. Hence, this implied an even bigger adverse impact on LTCM portfolio of securities. Indeed, as LTCM was a counterparty for several derivatives transactions, large financial institutions run away to avoid negative effect LTCM will have if it defaults. This exposed a fallacy of Merton’s models : in a crisis, traders behave emotionally, not logically. LTCM never considered the “Human Factor”. 5) Describe how LTCM created systemic risk Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. LTCM held contracts around the world, and if it defaulted, its counterparts around the world would all try to sell at once. This would result in a bank run, and the Wall Street banks could lose $2.8 billion. As LTCM’s equity shrank, its debt grew to more than 100 times its equity. A one-percent loss would wipe it out. Only two options existed : let the fund fail and risk a worldwide crisis or have all of Wall Street’s banks collaborate on a bailout. 6) Describe the solution orchestrated by the New York Federal Reserve, with 14 banks contributing USD 3.65 billion in capital After difficult, angry negotiations, almost every Wall Street bank agreed to put in $300 million (14 banks in total). The banks will take over 90 % of LTCM’s equity and the initial partners will have to commit to three years each, but under the supervision of the new owners. The bankers agreed on a three-part agenda : reduce the fund’s risk level, return capital to the new investors, and last, try to realize a profit. Even after the bailout was made public, it nearly collapsed many times, but at the last possible moment, $3.65 billion was transferred to LTCM’s account. 2 Book 2 : This Time Is Different by Reinhart and Rogoff 1) Describe crises by type : inflation crises, currency crashes, banking crises, external debt crisis, domestic debt crisis (Chapter 1) - Inflation crises : The beginning of an inflation crises is defined by a threshold. Many high inflations were chronic and lasted many years. We can use a twelve-month inflation threshold from 20 to 40 percent (e.g., World War 2). For some period (World War I), this inflation is too high, lower average inflation and little expectation of high inflation. Higher inflation crisis was in Hungary 1946. Hyper-inflations : inflation rates of 40 percent per month - Currency crashes : Large nominal exchange rate depreciation and a threshold of 25 percent per annum. The currency threshold depends on the period and the amplitude of movements. Looking at the full period in which annual depreciation exceeded the threshold, we remarked the crashes are similar in timing and magnitude to the profile of inflation crises. Higher currency crash was in Greece 1944. - Banking crises : This approach is suitable because of the lack of long-range time series data. For instance, the relative price of bank stocks to the market is a good indicator but in the earlier sample, many banks don’t have publicly traded equity. Moreover, a better indicator is the changes in bank deposits to date crises. The banking crisis is marked by bank runs and withdrawals. Keep in mind, the banking problems arise not from the liability side but from a deterioration in asset quality. Indeed, the nonperforming loans are often widely inaccurate because banks try to hide their problems as long as possible. In this book, authors mark a banking crisis by two events : a) Bank runs that leads to the closure, merging or takeover by the public sector of one or more financial institutions. b) Governmental assistance : If there are no runs, closure, merging, takeover but governmental assistance of an important financial institution. The banking crises are classified as systemic (severe) or financial distress (milder) In conclusion, this approach contains drawbacks as dating the financial problems too late or too early. - External debt crises : Involve outright default on a government’s external debt obligations. In other words, a default on a payment to creditors of a loan issued under another country’s jurisdiction. Often, this loan denominated in a foreign currency and held by foreign creditors. The external default dates are clearly defined and less contentious than the dates of banking crises. Moreover, a formal agreement with 1  creditors often marks the termination but it’s quite interminable (e.g. Russia hold record with 69 consecutive years). - Domestic debt crises : Domestic debt is often denominated in the local currency and held by residents. In fact, the domestic debt crises information is scarce. This crisis occurs against a backdrop of much worse economic conditions than the average external default. In academic literature and financial press, this kind of crisis is often underrepresented. In other words, a domestic default which doesn’t contract a new default on external debt (involving non-residents) is scarcely known in the literature. The many defaults on domestic debt occurred during the Great depression of the 1930s in both advanced economies and developing ones. Finally, like banking crises, the domestic default endpoint isn’t easily established. 2) Describe serial default (chapter 1) Multiple sovereign defaults on external or domestic public debt. These defaults may occur five or fifty years apart. They can range from wholesale default (repudiation to partial default through rescheduling (stretching out the interest payments). However, the wholesale default is actually quite rare. 3) Describe debt intolerance and debt thresholds (chapter 2) - Debt intolerance : It’s the vulnerability to marginal rises in debt. In other word, it’s a syndrome in which weak institutional structures and a problematic political system make external borrowing a tempting device for governments to employ to avoid hard decisions about spending and taxing. Indeed, the debt intolerance is defined as the extreme duress (constraint) many emerging markets experience at external debt levels that would seem quite manageable by the standards of advanced countries. This duress involves a vicious cycle of loss in market confidence, spiraling interest rates on external government debt and political resistance to repaying foreign creditors. - Debt thresholds : According to the country, a credit event (=default) can and does occur at ratio of external debt/GNP that are far lower than developing country. Different levels of debt intolerance imply very different thresholds for various countries. The countries’ repayment and inflation histories matter significantly; the worse the history, the less the capacity to tolerate debt. The thresholds of external debt to GNP are easily biased upward because the ratios of debt to GNP corresponding to the years of the credit events are driven up by the real depreciation in the exchange rate that accompanies such events as locals and foreign investors flee the currency. In general, the defaulters borrowed more than the non-defaulters. 2 4) Describe how to measure vulnerability (chapter 2) We have two indicators to measure vulnerability : - Institutional Investor Ratings (IIR) : report the sovereign ratings based on survey information provided by economists and sovereign risk analysts at leading global 9 banks and securities firms. The ratings grade each country on a scale from 0 to 100, with a rating of 100 given to countries perceived as having the lowest likelihood of defaulting on their government debt obligations. Therefore, a proxy of default risk is 100 minus IIR. - External debt to GNP/Exports : We define the total external debt as public + private. Majority of the government debt is external and a small part of external debt that was private before crisis but often became public after the fact. 5) Differentiate between illiquidity and insolvency (chapter 4) - Illiquidity : When a country/firm faces a short-term funding problem : the subject is fundamentally sound but is having difficulties sustaining confidence because of a very temporary and easily solvable liquidity problem (=insufficient cash). When a country borrows short-term, this latter has to pay financing interest payments and roll over the principal. A liquidity crisis occurs when a country that is both willing and able to service its debts over the long run find itself temporarily unable to roll over its debts. A borrower can merrily roll along as long as lenders have confidence. Moreover, a third party can make a short-term bridge loan, with no risk, which will keep the borrower on its feet and prevent it from defaulting. - Insolvency : When a country/firm is not willing and/or able to service its debts indefinitely or over the long run : the subject is so highly leveraged and so poorly managed that it takes very little to force it into default. - The short-term borrowing enhances the risk of a financial crisis when debt cannot be rolled over. Indeed, countries are forced to follow more disciplined policies, improving economic performance for debtor and creditor alike. 6) Describe partial defaults and debt rescheduling (chapter 4) - Partial default : Most of defaults end up being partial, not complete, albeit after long contentious negotiations and much acrimony. Creditors may not have the leverage to enforce the full repayment, but they do have enough leverage to get at least something back, often a significant share of what they are owed. 3  - Debt rescheduling : The debtor forces its creditors to accept longer repayment schedules and often interest rate concessions. The agreed rescheduling minimizes the deadweight costs of legal fees and other expenditures. 7) Describe external default (chapter 6) The combination of the development of international capital markets and the emergence of a number of new nation-states led to an explosion in international defaults. Historically, all countries have defaulted on external debt at least once and many have done so several times during their emerging market-economy phase. In other words, the frequency of default on external debt is significantly lower in advanced economies than in emerging markets. 8) Discuss the link between default and banking crises, default and inflation (chapter 5) Link between default and banking crises : A high incidence of global banking crises has historically been associated with a high incidence of sovereign defaults on external debt. The sovereign defaults began to climb in World War 1 and continued to escalate during Great depression and World War 2. 1. The banking crises in advanced economies significantly drag down world growth. The slowing of economic activity tends to hit exports hard, limiting the availability of hard currency to the governments of emerging markets and making it more difficult to service their external debt. 2. Weakening the global growth is associated with declining world commodity prices which reduce the export earnings of primary commodity producers and their ability to service debt. 3. Banking crises produce a ‘’sudden stop” of lending to countries at the periphery. With credit hard to obtain, economic activity in emerging market contracts and debt burdens press harder against declining governmental resources. 4. Banking crises is “contagious” in that investors withdraw from risk-taking and reduce his overall exposure as his wealth declines. Moreover, this crisis in one country can cause a loss of confidence in similar countries. Link between default and inflation : The banking crises indicates a likely rise in sovereign defaults. It may also signal a potential rise in the share of countries experiencing high inflation. This latter represents a form of partially defaulting on government liabilities that are not fully indexed to prices or exchange rate. Indeed, default through inflation became more commonplace over the 4  years as fiat money displaced coinage as the principal means of exchange. The correlation between inflation and external default has doubled in 20th century which can be explained by the abandonment of a gold standard rather than by a change in macroeconomic influences. Finally, a high background of inflation makes less likely that an economy will be pushed into a downward deflationary spiral where debt burdens become even more onerous and detrimental to economic performance. 9) Describe domestic default and why it occurs (chapter 7) Domestic public debt is issued under a country’s own legal jurisdiction. In most countries, over most of their history, domestic debt has been denominated in the local currency and held mainly by residents. Usually, domestic debt crises do not involve powerful external creditors and are usually less noticed. The domestic debt is significantly the largest portion of total debt, and the government repressed their domestic financial markets with low ceilings on deposit rates and high requirements for bank reserves. A government refuse to pay its domestic public debt in full. It inflates the problem away : government can achieve a significant real reduction in debt services payments. This inflation causes distortions to the banking system and the financial sector. The potential costs of inflation are problematic when debt is short-term or indexed. 10) Compare domestic and external default (chapters 6 and 7) - External default : creditors are a mix of residents and non-residents “contagion effect” - Domestic debt crises typically occur against a backdrop of much worse economic conditions than the average external default. - Domestic defaults are far more difficult to detect than defaults on international debt. - Output declines in the run-up to a default on domestic debt are significantly worse than those on external debt. - Inflation rate is largely higher during domestic default (170%/y) than external default (∼30%/y). After the default, inflation will remain above 100%. 11) Describe banking crises and their link to capital flows, housing price cycles (chapter 10) Banking crises : Banking crises have long impacted rich and poor countries alike. These crises are more often an amplification mechanism : a reversal of fortunes in output growth leads to a string of defaults on bank loans, forcing a pullback in other bank lending, which leads to further output falls and repayment problems : 5  - Banking crises are accompanied by other kinds of crises as exchange rate crises, domestic and foreign debt crises and inflation crises. - In general, a country will spend less time in financial crisis than in a state of sovereign default. However, it’s costlier to leave a domestic banking crisis due to the crippling effects on trade and investment. - The incidence of banking crises proves to be similar in both high-income and middle- to-low-income countries. These banking crises almost lead to sharp declines in tax revenues and real government debt rises by 86% during the three years following a banking crisis. - The maturity transformation (i.e., transforming short-term deposit funding into long- term loans) makes them vulnerable to bank runs. Housing price cycles : The real estate price cycles around banking crises are similar in duration and amplitude across countries despite of the fact most macroeconomic variables exhibit greater volatility for emerging economies. The banking crises tend to occur either at the peak of a boom in real housing prices or right after the bust (= equal- opportunity menace). Capital flows : there is a positive correlation between free capital mobility and the incidence of banking crises. Indeed, periods of high international capital mobility (=liberalization) have repeatedly produced international banking crises. In other terms, the financial liberalization has an independent negative effect on the stability of the banking sector. The authors use the term of “Capital flow bonanza”. The probability of a banking crisis conditional on a capital flow bonanza is higher than the unconditional probability. 12) Discuss inflation and modern currency crashes (chapter 12) Inflation crashes : Many countries in different continent experienced a significant number of years with inflation over 20% per year and most experienced an inflation over 40%. However, there exists countries as New-Zealand and Panama which did not experience any periods of inflation over 20%. More recently, experienced waves of high and very high inflation exceeding 40% per annum. Indeed, in Africa and Latin America, we find the highest share of countries with inflation over 20%. Currency crashes : Inflation crises and exchange rate crises have travelled hand in hand in the overwhelming majority of episodes across time and countries. During the Napoleonic wars, exchange rate instability escalated to a level that had not been seen before. The share of countries with annual depreciation rates greater than 15% is more and more concentrated in the 20th century. 6 13) Discuss dollarization (chapter 12) Countries with high inflation often experience dollarization, a huge shift toward the use of foreign currency as a transaction medium, a unit of account, a store of value and as indexation of bank accounts/bonds/other financial assets. - Inflation : Successful disinflations have not been accompanied by large declines in the degree of dollarization (≠ sufficient condition). Indeed, the persistence of dollarization is consistent with the evidence on “hysteresis”, i.e., the tendency for a country that has become dollarized to remain so long after the original reasons. Moreover, this persistence is a regularity that tends to be associated with countries’ inflation histories; countries that repeated bouts of high inflation over the past few decades generally exhibited a higher degree of dollarization in the late 1990s. - Exchange rate : There is a relationship between the level of dollarization and exchange rate histories. Parallel market exchange rates and pervasive exchange controls have been the norm. Conversely, few countries with hard pegs and unified exchange rates have experienced high inflation. Domestic dollarization : Some countries tried to manage to reduce their degree of domestic dollarization. To identify these countries, we separate into two cases : 1. The reduction in domestic dollarization originated in a decline in locally issued foreign currency public debt. First, a country can amortize the outstanding debt stock on the original terms and discontinued the issuance of those securities. Secondly, country can change the currency denomination of the debt using market- based approaches. 2. The reduction in domestic dollarization originated in a decline in the share of foreign currency deposits in broad money. We look at the ratio of foreign currency deposits which has to satisfy the following three conditions : 1) Experienced a decline of at least 20% 2) Settled at a level below 20% immediately following the decline. 3) Remained below 20% until the end of a sample period. In this book, only 4 of 85 countries met the three criteria : Israel, Poland, Mexico, Pakistan. 14) Describe the U.S. subprime meltdown (chapter 13) The U.S. subprime began in the summer 2007 and historically was one of the most severe. There was a global account imbalance that preceded the crisis. The outsized U.S. 7  borrowing from abroad was the only warning signal. There were other signs of being on the brink of a deep financial crisis. Indeed, measures such as asset price inflation, most notably in the real estate sector, rising household leverage and slowing output. This U.S. subprime was firmly rooted : 1. The bubble in the real estate market fueled by sustained massive increase in housing price. Between 1996 to 2006, the cumulative real price increased was about 92%-more than three times the 27% of 1890 to 2006. In mid-2007, a sharp rise in default rates on low-income housing mortgages in USA. Moreover, the chairman of FED, Alan Greenspan, argued that financial innovations such as securitization and option pricing were producing new and better ways to spread risk, e.g., making illiquid assets, such as houses, more liquid; these new financial instruments were allowing many new borrowers to enter mortgage markets. This latter was approximately 90% of GDP. Therefore, higher, and higher prices for risky assets could be justified. 2. A massive influx of cheap foreign capital resulting from record trade balance and current account deficits. According to Greenspan, it is not a primary risk factor but a secondary issue. 3. A permissive regulatory policy that helped propel the dynamic between these factors. 15) Describe the aftermath of financial crises (chapter 14) The aftermath of severe financial crises shows that these crises have had a deep and lasting effect on asset prices, output, and employment. The aftermath shares three characteristics : 1. Asset market collapses are deep and prolonged. The real housing prices average declines by 35% whereas equity price collapse by 56% on average. 2. The aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises by 7% on average during the down phase of the cycle. Moreover, outputs fall more than 9% on average. However, the duration of the downturn is shorter than that of unemployment. 3. The value of government debt tends to explode; it rose an average of 86%. Indeed, the biggest driver of debt increases is the inevitable collapse in tax revenues that the government suffer in the wake of deep and prolonged output contractions. 8