Every year, around the world, trillions of dollars in government securities are purchased at treasury auctions to finance public debt. How well that process works can affect interest rates at your local bank and on Wall Street — and how quickly you can save money for your children’s education and your own retirement.
Kristian Rydqvist has made a life’s work out of making sense, not to mention theory, of the intricacies of financial markets and the economic principles that drive them.
Rydqvist, who joined the University last semester, is the Zurack Professor of Finance and Economics, a newly created professorship established through a gift from Mark A. Zurack ’78, a former partner and managing director of equity derivatives at Goldman, Sachs & Co., Manhattan. The Swedish-born economist was appointed to the University’s first joint professorship after five years at the Norwegian School of Management, Oslo.
Widely published in American and international journals, Rydqvist is concentrating his current research in the areas of auction theory, tax arbitrage and proxy voting.
An empiricist who relentlessly scours data sets for insights, Rydqvist says it can take years before any given project is completed, including several rounds of revision, with work on one paper leading to subsequent papers.
In addition to his research interests, Rydqvist will teach several undergraduate and graduate courses, including one in the Executive MBA program.
The Zurack professorship is not Rydqvist’s first taste of American universities. After earning his PhD in economics from the Stockholm School of Economics, he was a post-doctoral fellow at Northwestern University before returning to his alma mater, where he taught for five years. From there, he held visiting professorships at the University of Michigan, Carnegie Mellon University, Indiana University and the University of Wisconsin-Madison.
Two things drew Rydqvist to the United States: his U.S.-born wife has family in Boston and Ohio, and in terms of economics and finance scholarship, “virtually everything in financial economics happens in the U.S,” he said. On the other hand, he added, “There is a lot in Europe that does not happen in the U.S.”
When it comes to testing and proving theoretical propositions in finance and economics, researchers strive to find just the right real-world data sets to make their case. For Rydqvist, that meant looking in his own backyard, drawing material from Swedish sources, as well as looking at sources nearby countries including Denmark, Finland and, soon, Norway.
His work on auction theory, for instance, draws primarily from Swedish treasury auctions, but he is currently working on a paper with two other scholars that draws data from Finnish treasury auctions. Swedish data on the sale of lottery bonds, a one-of-a-kind financial animal not found in the United States, also provided Rydqvist grist for additional research on tax arbitrage and an apparent anomaly in the widely accepted capital-asset pricing model studied in all major business schools today.
One of Rydqvist’s goals is to improve the general model of asset pricing. “We want to determine the price,” he said. “The primary variables under investigation are agents’ risk aversion, information and tax position.”
To accomplish this, Rydqvist uses data sets on Swedish lottery bonds. “A lottery bond can be regarded as a package of zero- coupon bonds and a basket of lottery tickets that provides the holder with the right to participate in X-number lotteries,” he said. “By purchasing block bonds in sequence, the holder can guarantee winning one of the small payments. In addition, each bond participates in the lottery for all the large prizes.” The largest prizes are 1 million kroner — about $120,000.
“The market for Swedish lottery bonds provides a unique laboratory to evaluate the degree to which these basic principles are reflected in actual market prices,” Rydqvist said. What intrigues him about the bonds is that according to one of the most basic theorems of finance — the capital asset pricing model — the bond’s selling prices should not carry a risk premium.
“Theory says that lottery risk is irrelevant to pricing, because a lottery has no aggregate risk,” he said. The thought is that lottery risk can be diversified completely by purchasing all the lottery tickets in a given sequence. But, to Rydqvist’s surprise, that was not the case — not only in the Swedish data he studied, but more recently, in data from similar Danish lottery bonds.
Buyers, he found, prefer the bonds only when they can buy them in sequenced blocks, but shy away from or underbid blocks with mixed number sequences. “Buyers do not like the lottery and buy the bonds only at reduced prices or, equivalently, higher yields,” he said.
This deviation in price from what the model suggests it should be is a wrinkle in the capital assets model that Rydqvist will continue to research. “This idea is central to research methods, policy recommendations and pedagogy in finance,” he said.
Rydqvist said the importance of the capital asset theory cannot be overstated: “It has far-reaching practical implications for investors saving for their children’s education and their own retirement, as well as for corporations making investment decisions.” Thus, any improvements he can make in understanding the theory could be a major breakthrough.
One aspect of this new inquiry area for Rydqvist is considering whether investor information and knowledge play a role in the pricing differential. “Because the bonds are tax exempt, this market is dominated by individuals rather than institutions, and the marginal investor may be unsophisticated,” he said. That insight, if proven, may explain the apparent theoretical quirk. But Rydqvist noted, “While there is nothing in asset pricing theory that excludes retail investors, our conclusions may not generalize to markets where competitive forces have freer rein.”
The tax arbitrage aspect of the bonds — or profiting from differential tax rates on securities traded for capital gains and losses, versus those retained for the more heavily taxed dividends — is another area of interest. In doing their research, Rydqvist and his co-author sought to find a data set that would help prove their working assumption that the selling price of securities is tied to the way revenues or losses are taxed. What they settled on was 11 years’ worth of data from Swedish lottery bonds — a security instrument with unique characteristics — and a tax treatment that was the reverse of how American stocks are treated.
In the United States, among high-end investors there is a distinct preference for investments taxed as capital gains at a lower rate, than investments whose dividend earnings are taxed as ordinary income at a higher rate. In contrast, cash revenues from the Swedish bonds are not taxed, and the capital gains are taxed. Rydqvist’s supposition was that Swedish investors would prefer the dividend income over capital gains, and he reasoned that in the United States, the reverse should be true also because of tax treatment. The bond’s tax structure and the fact that — like stocks — these bonds can be traded without dividend, is an arrangement that allows their sale to be tracked in a way that makes the seller’s tax preferences clear. Bond selling prices, with or without the dividend, should be adjusted by the market to take into account the tax implications and thus become a “neutral” factor — meaning that taxes, as opposed to other market conditions, are the driving factor.
This discovery has meatier implications for economic theory and beyond. “How such differential taxation influences security prices has financial consequences for corporations and governments that issue securities, and policy implications for governments that design tax codes and rely on tax revenues,” he said.
Another study area that has potential for wide-ranging implications is his work on Swedish treasury auctions. He and colleagues researched data from 400 auctions of Swedish treasury debt instruments ranging from short-term treasury bills with 14-month maturities to bonds with maturities from six to 16 years. What they found is that when faced with uncertainty in the marketplace — meaning volatility in interest rates and uncertainty in their ability to re-sell the debt on the secondary market — investors tend to bid in smaller lots and at lower rates and disperse their bids. What the bidders are doing is shaping their strategy to avoid suffering from what’s called the “winner’s curse” or “champion’s plague” — the phenomenon that occurs when buyers pay too much for merchandise because they lack precise information.
He explains, “It is well known from experiments that bidders in common value auctions overbid and lose money. In the treasury market, with its enormous volumes, overbidding would quickly lead to the default of all the primary dealers such as Goldman Sachs, etc. Hence, they rationally adjust for winner’s curse and bid below what they think is the resale price of the security. As a result of rational underbidding, they make a profit.”
But, Rydqvist notes, while such strategies are necessary to preserve market equilibrium, the phenomenon also has side effects that stretch beyond the market: “In short, when uncertainty is higher, the winner’s curse is higher — leading bidders to bid more cautiously, thus lowering expected revenue to the seller.” In the case of governments, that may mean going to the debt market more often. All these possibilities also have consequences for ordinary citizens, as changes in the government debt market trickle down in the form of rising or falling interest rates, tight or loose credit availability, and positive or negative pressures on wages and prices.
Rydqvist’s scholarship strives to establish mathematically derivable economic laws that should govern the situation, rather than create policy. But, as in the auction case, the lottery-bond lessons can provide cues that extend beyond financial markets.
Reading Rydqvist’s work — crammed with highly technical financial terms such as “heteroscedasticity” and sprinkled with math formulas that are, literally, Greek to the non-initiated — it would be easy to pass it off as ivory-tower scholarship. But as Rydqvist explains, understanding the models at play in economics and finance has real implications for policy makers. One aspect common to all of Rydqvist’s work is that he attempts to work with large data sets, so his conclusions are well grounded in experience and do not represent statistical hiccups or anomalies.
A big-picture theorist, Rydqvist seems to prefer the rule to the exception and sees economics and finance more as a quantifiable science than an intuitive art.
