In financial economics, it is assumed that individual and institutional investors behave differently in the market. While institutions are viewed as informed traders, individuals are considered as noise traders with psychological bias as in Kyle (1985) and Black (1986). In particular, Choe et al. (1999) and Kaniel et al. (2008) examine the difference of individual investor trading in stock markets and its impact on the dynamics of stock prices. Based on these works, this paper aims to show how individual investors affect volatilities as well as stock returns, and whether individuals are uninformed traders of volatility trading. Our study, however, differs from the previous studies in that we focus on options markets instead of stock markets. There are two reasons that we examine the behavior of individual investors in options market other than in the stock market. First, according to the previous studies individual investors’ behavior in options markets is inconsistent with their behavior in stock markets. Individual traders heavily depend on the changes of past prices and prefer out-of-the money options that have a severe leverage effect, which is significantly different from institutional and foreign investors. These unique characteristics of individual investors in options markets have made us interested in looking into the relationship between individual investors and options markets. Second, the structure of options markets is, in nature, optimal for analyzing the effect of each type of investors. When studying its impact using stock returns, we have to pay much attention in order to adjust for the effects by various factors such as dividends and stock-splits. However, we an easily adjust the effect of underlying asset returns on option returns using the series of options with different strike prices and different maturities, thereby simplifying our research design. As well-known, volatility is the measure of the price level which is adjusted for the effect of underlying asset. In short, if stock trading is based on the prospect about the future direction of underlying asset prices, option trading is based on that about the future direction of volatility. Therefore, it is called volatility trading. Although this paper investigates the behavior of individual investors in stock markets based on the idea of Kaniel et al. (2008), it differs from the study. While it solely focuses on the role of individual investors as liquidity providers in stock markets, our paper deals with the change of volatility by the behavior of individuals in the options market. Thus the aim of this paper is to see whether their interpretation holds valid in the volatility trading in the options market. In this paper, we analyze the autocorrelation between implied volatilities, including implied volatility of at-the-money options, and VKOSPI 200 index which results from calculating one-month model-free implied volatility using out-of-the-money KOSPI 200 index options. In addition, we examine whether volatility changes can be explained by the intensity of the buying/selling of individual investors using regression analysis, even after adjusting for the mean reverting of implied volatilities. For our second study, we sort data into ten decile groups according to the intensity of the buying/selling of individuals as a proxy for trading imbalances. Decile 1 is the most intense selling period and decile 10 is the most intense buying period. Then we examine buying/ selling imbalances and trading patterns of individuals in terms of the trend in simultaneous and cumulative volatility changes of deciles 1 and 2 and deciles 9 and 10, prior to, current, and after trading week separately, and calculate t-statistics of cumulative volatility changes for testing significance. The main results of this paper can be summarized as follows. First, we find that implied volatility is mean-reverted and that as the intense buying by individuals increases, so do current and future implied volatilities. Second, the imbalance of volatility between intense buying and selling is analyzed for each decile. According to the results, volatility significantly increases when individuals become only intensely buying options, which is likely to be consistent with the fact that individuals are net buyers in options markets. Finally, we investigate volatility change prior to, current, and after trading week and recognize that individuals are volatility-momentum traders who tend to buy options after volatility increases. Also the results of the robustness test indicate that the effect of individual investors on volatility is still significant after controlling for the total volume of options and the realized volatilities of underlying assets. Therefore, we can conclude that the information contained in the intensity of individual buying and selling is independent of information contained in the total volume and realized volatility.

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The globalization and integration of financial markets across border is an inevitable phenomenon, in line with which even emerging economies including Korea have opened their financial markets to international investors. With increasing globalization in capital markets, the cross border capital flow has become an important issue because it is directly related to vulnerability of small and open economies. In the past decades, the international financial economics literatures examine the effect in relation of the return of price and volatility transmission between stock markets (Hamao et al., 1990, Karolyi, 1995; Ng, 2000; Singh et al., 2010) or between index or commodity futures markets (Roope and Zurburegg, 2002; Xu and Fund, 2005; Liu and An, 2011). Although some studies examine the relation in currency markets, their focus is limited to price return and volatility transmission between major currencies such as Japanese Yen, Deutsch Mark, and British Pounds (Baillie and Bollerslev, 1991; Hong, 2001) or between European currencies (Baele, 2005; Bubák et al., 2011). No study so far has examined those between the currencies in the Asian region, so this paper is in fact the first of its kind to do so. As such, the purpose of this paper is to examine the dynamics of price discovery and volatility transmission between Korean Won (KRW), Chinese Yuan (CNY), and Japanese Yen (JPY). We use the US dollar, which has been used for payment and settlement in international trades, as the numeraire for evaluating the three currencies and gold. Historically, Japan has been the most influential economy for Korea next to the US. Korea and Japan have similar economic structure and geographical proximity to each other. Meanwhile, China’s economy has grown rapidly since 1990’s and has become the second largest economy in term of GDP in the world. Accordingly, its economic influence on Korea has also rapidly grown, and since 2006 it has been Korea’s biggest trade partner, replacing Japan. Hence, we conjecture that some power shift must take place from Japanese yen to Chinese yuan in terms of these currencies’ influence on Korean won. Subsequently, we conduct studies to understand how the three currencies are interrelated in term of the price discovery and volatility transmission. Our study period is from Aug. 1, 2005 to Nov. 7, 2012 since China was under the fixed exchange rate regime before Aug. 1, 2005. We also remove the period from Jul. 1, 2008 to May 31, 2010 from the above because China temporally enforced the fixed rate system during this global financial crisis (hereafter GFC) period. As a consequence, our sample period is divided into two sub-sample periods. The first one is from Aug. 1, 2005 to Jun. 30, 2008, which is before the GFC period. The other one is from Jun. 1, 2010 to Nov. 7, 2012, which is after the GFC period. To investigate the price discovery, we employ Hasbrock’s (1995) information share measurement method. Our findings are follows: Before the GFC, the contribution of JPY for the price discovery of KRW is rather high while the contribution of CNY for the discovery of KRW is low. However, after the GFC, the price discovery contribution of CNY on KRW becomes quite significant whereas that of JPY diminish. To identify the volatility transmission, we use a multivariate volatility model, BEKK. However, since we should analyze four variables, we decide to employ the rotated multivariate GARCH model (hereafter MRARCH) of Noureldin et al. (2012) for numerical stability. Using this model, we find that there is no significant volatility transmission between JPY, CNY, and KRW before the GFC. However, the influence of CNY towards KRW and JPY in volatility transmission becomes apparent after the GFC. We suggest that increased role of CNY in volatility dynamics for Korea is caused both by the increase in the trade volume between China and Korea and by the rise of China’s economic status in the world market. Although we can not get some strong evidences in terms of statistical significances, our empirical results support that there is a relative influence power shift from JPY to CNY before and after the GFC. This is the first systematic empirical work to find the linkage between the major currencies in Asia region. We hope that this study trigger further research on the multivariate currencies dynamics in the region.

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This paper develops a new credit risk model for small and medium-sized enterprises (SMEs) based on the DSW model of stochastic default intensity and the dynamics of underlying time-varying covariates. In particular, our model incorporates the default probability with the probability of initial public offerings (IPOs) in the framework of a censored stopping-time model. Default stopping time comprises of such variables as total borrowings/total assets in the stability, ROA in the profitability, account payable/sales in the activity, and financial expenses/total cost in the etc. As for the IPO stopping time, the natural log of total assets in the stability, net income/net sales in the profitability, and cash flows from operating activities/ net sales in the etc. are significant for the IPO stopping time. It is found that our model based on DSW model outperforms the multi-period logit model consistently and robustiously according to various prediction horizons and lag orders of VAR for macro-variates because the continuous stopping-time framework emphasizing on the stochastic default intensity accurately calculates the default probability superior to the discrete-time model equivalently computing the survival and default probability. In addition, it captures countercyclically monthly-frequency movement of capital requirements in compliance with the new Basel Accord. The implication is that our model as the early warning system may help the financial supervisory authority to predict the expected loss due to the sudden collapse of economic fundamentals such as rapid transfer of debtors' credit risks.

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Household debts have become an increasingly influential factor in holding financial assets (Cocco, 2005; Yao and Zhang, 2005; Chetty and Szeidl, 2009; Becker and Shabani, 2010). This paper therefore investigates the impact households’ debts have on their holding status of various financial instruments by examining the data of 10,000 households from the 2011 and 2012 Household Financial Survey conducted by Statistics Korea. In exploring the relations between household debts and household financial asset holdings, this study specifically addresses two issues. One is about the extent to which household debts across household income classes have an impact on the shareholdings of each financial instrument. The other is about the sway of household debts on the choices of three financial instruments at the moment households make asset allocation decisions. Some evidences are found on the relation of households’debt and financial asset holdings. First, while financial asset holdings as well as household debts increase in proportion to a certain age up to 60, they drop sharply afterwards. The ratio of financial asset over total asset exhibits a U-shaped distribution. This result can be explained by the fact that Korean households in general have strong tendency to demand real estate relative to financial assets, and this preference is more pronounced as age increases. In addition, both financial asset holdings and household debts increase proportionally to the education level of households, while the ratio of financial asset or financial debts over total asset shows a moderately inverted U-shaped pattern. These results seem to imply that the better educated and the older households, the more capable they become in employing debt instruments either in financial or real assets as tools to accumulate wealth. To explore the relation of household debt and financial asset holdings, dependent variables such as fin, risky assets, and cash are normalized by dividing financial wealth, risky assets, and cash by total assets. With the scaling of dependent variable being equal to or greater than zero, Tobit regressions are conducted while, for the purposes of model setting, controlling for either one or combination of categories of different levels of education, industries, and occupations. Besides, to control for the endogeneity of household debts with financial asset holdings, I use the predicted household debt ratio as an instrument variable estimator obtained from running 2SLS. The second finding is that the impact of household debt ratio on financial wealth holdings is plainly pronounced among household income classes based on the analysis of the samples of 2010 in quintiles, although the household debt ratio in the whole sample negatively dominates the holdings of three financial instruments. In particular, the household debt ratio negatively affects the holdings of financial wealth in middle income class, whereas it positively does in high income class. This result indicates that the debt ratio of high income households plays a complementary role to financial wealth holdings, but, in contrary, the debt ratio of the middle income households substitutes financial asset holdings. Further, this finding implies that high income households take advantage of debt to accumulate wealth by investing in both financial assets (Pollin, 1988, 1990) and real estate, while middle income households do not hold both together, probably owing to credit constraint. However, high income households owning real estates are more inclined to reduce the holdings of both risky assets and cash holdings. Third finding is about asset allocation across household income classes. The financial debts in middle income households shrink the holdings of financial wealth, risky assets, and cash, whereas the disposable income in middle income class raises the holdings of the three major financial vehicles. But the financial debts in high income class increase the financial wealth, but reduce the cash holdings. Additionally, when the sample is restricted to households with debts, then financial debts reduce both financial wealth and risky assets, but raise the level of cash holdings. Taken together, these results generate two possible interpretations: the extent of the impact of financial debts over asset allocation varies depending on either household income classes or the levels of household debts. As a robustness check, I carry out the Tobit models using the 2011 sample. Unfortunately, the effect of household debts on financial wealth for the high income class only is consistent with the result in the prior year sample. This research is restricted to the two survey period samples and there are, therefore, limitations to fully take in the features of households behaviors on asset holdings and asset allocation in relation to household characteristics over time. I have a good guess about the asset holdings and choices by households in 2010 and 2011, which were unduly influenced by the 2008 Subprime Mortgage disaster. One of future research is possibly the comparison with changes in households asset holdings in terms of household debts and income before and after 2008 financial crisis.

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To examine the common assumption that the monetary fundamentals are stationary, we test the monetary model of exchange rate determination. In specific, we test whether nominal exchange rates are cointegrated with the monetary fundamentals, using data spanning from January 1971 to March 2011. The results show that the Phillips and Ouliaris test fails to reject the null of no cointegration while we reject the null hypothesis of no cointegration with Johansen’s trace test. We also explore the out-of-sample forecasting performance of the long-horizon regression of exchange rate returns on the deviation of the log exchange rate from the monetary fundamentals. For the sample of data, the DOLS estimation does not yield cointegrating coefficient estimates that accord with the theoretical values implied by the monetary model of exchange rate determination. This may bring about critical results asserting that there is no evidence of exchange rate predictability based on the monetary fundamentals in the sample. Despite the use of long span data, no evidence is found in favor of the monetary exchange rate model using the Johansen procedures. We compare the out-of-sample forecasting performance of the monetary model and confirm that forecasting power of the monetary model is insignificant.

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Up to now, major Korean data vendors have provided financial researchers with partially adjusted stock price data. As a result, holding period returns and the number of shares outstanding are sometimes inaccurate. This is a serious problem since stock price data are the most important ingredient for financial studies. To remedy this problem, benchmarking the methodologies used in the Center for Research in Security Prices (CRSP), we construct the Korean stock price data (1999. 12~2011. 09) which fully reflect corporate actions. We then investigate how security prices affect empirical studies in financial economics, with a particular focus on the effect of cash dividends. To begin with, we compute holding period returns and the number of shares outstanding by taking into account the effect of any corporate action. Though our approach is based on the methodology of the CRSP, it is modified to reflect the Korean stock market practices. By crosschecking several corporate event data sources, we build fully adjusted stock price data. The construction procedures are as follows. First, we categorize corporate events into nine large groups: Cash dividends, liquidations and transfers of exchange, mergers and splits, paid-in capital increases, capital increases without consideration and stock dividends, capital decreases and retirements of shares, stock splits and reverse stock splits, stock conversions and stock options, and other outstanding share changes. The nine large groups are subdivided into the smaller groups. Second, we examine all corporate events during our sample period. Since all corporate events except cash dividends, and liquidations and transfers of exchange entail the change of outstanding shares, we can inversely trace the corresponding corporate event when changes in outstanding shares are discovered. Although there are a few corporate actions in which outstanding shares are unchanged, those actions can be checked by the Korea exchange (KRX) corporate action data. Examples include stock split after reduction of capital stock without any refund. Third, we investigate the corresponding effective-dates of all the corporate events. Generally, there are two-or three-week gaps between the dates in which outstanding shares actually changed and the corresponding effective-dates, and this time disparity stems from related administration processes. Yet, these time gaps cause some erratic results because investors recognize that corporate events take place at the effective date but the changes of outstanding shares happen a few weeks later. Due to this time gap, firm sizes can be miscalculated. Accordingly, we revise the stock price data so that the changes of outstanding shares occur at the corresponding effective-dates and thus the gaps are removed. Basically, we check the effective-dates in Data Analysis of the Retrieval and Transfer System (DART) of Financial Supervisory Service (FSS). Also, the excess of daily limit of price variation is helpful in detecting the effective-dates because the excess indicates that there is a corporate event such as stock split and capital reduction. Fourth, we calculate corresponding holding period returns at the effective-dates. For each event, the cash dividend amount and price adjust factor are figured out. Using the values, we calculate the accurate holding period returns at each effective-date through a simple equation. Then, we finally obtain the fully adjusted stock price data. With the accurately constructed stock price data, we study how our construction of security prices affects empirical studies in financial economics. To this end, we need a proxy for the risk-free rate. In this study, we use one month spot rate of a monetary stabilization bond as a proxy for the risk-free rate. Certificate of Depository (CD) rate, the prevailing alternative of risk-free rate in Korean financial market research, bears the default risk of banks as they are the issuers of CDs. Thus, CD rate has a serious flaw to be an alternative of risk-free rate. In contrast, monetary stabilization bonds issued by the Bank of Korea do not have default risk. Therefore, we adopt one month spot rate of the monetary stabilization bond from Korea Asset Pricing (KAP) as an alternative of risk-free rate. We then concentrate on the effect of cash dividends because researchers often overlook the effect they bring on the overall outcome when they conduct research. Instead, they usually use value-weighted index of the KOSPI and KOSDAQ as market portfolio. However, since these indices do not contain cash dividend returns, considerable biases can result from relying only them. This paper, therefore, points out that such biases indeed exist and how significant those biases are. The central empirical findings are as follows: First, while the average market excess return which reflects all corporate actions is 0.97% per month, the average market excess return which does not include cash dividends is 0.82% per month. Second, the annual CAPM alphas with security prices reflecting all corporate actions are 1.70%~1.85% lower than the ones that exclude cash dividends during our sample period. Finally, the estimated annual abnormal returns of equity funds are 1.32%~1.80% lower than the abnormal returns estimated with factors that do not include cash dividends. In sum, when the security prices that exclude the cash dividends are used in empirical studies, we find that holding period returns are underestimated, and, consequently, abnormal returns are overestimated.

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In this study we study the conflict of interests (COI) among customers of financial investment services companies (or securities firms) that operate diverse businesses in Korea as well as between the firms and their customers. Financial firms, in general, engage in diverse business activities with different customers, and each of business process has potential for COI between counter parties. For example, when a financial firm engages in a transaction with a customer, it gains valuable information about the client. Then, the possibility of COI arises because the firm has incentives to exploit the information to reap any kind of profit, perhaps to win additional deals for itself or a third party at that person’s expense. The root cause of a COI is the fact that a financial firm usually acts as an agent, and capitalizes from information asymmetry, often inherent in the firm’s transactions with individual customers. In this sense, financial investment services companies in Korea are appropriate subjects for this study for their diverse business areas for a wide array of customers, in which COI is very likely to emerge during their operations. In fact, some studies have been conducted on the COI in universal banking transactions at Korean financial investments services companies (securities firms). Those studies include Park and Shin (2007), Park, Choi, and Lee (2011). However, in general those institutions that provide universal banking services (e.g. securities firms in Korea) establish chinese walls to prevent the COI with another businesses. This creates difficulty in accessing data for COI cases. Another challenge is that many studies in this topic have produced conflicting results. In Lin and McNichls (1998), Kim and Choi (2008) and other related studies, they argue that affiliated analysts have the potential of COI. Cowen, Groysberg, and Healy (2006) and Park and Youn (2009), in contrast, insist that a possibility of that COI is lower due to maintaining their own reputation. As such, to increase objectivity of our study we select the most fundamental businesses of a financial investment services company: research analysis and underwriting. Then, we try to identify the COI in these core businesses. Specifically, we conduct an empirical analysis to verify the existence of COI in the Korean financial investment services companies, in this paper securities firms, focusing on measuring any possibility for biases that get involved in research analysis. The results of the study are as follows. First, it confirmed that analysts in Korean financial investment services companies (securities firms) working for an IPO underwriter tend to release less positive earnings outlooks and they had high accuracy in forecast. But our study results also indicate a possibility that COI in the industry could have stemmed from informational asymmetry among some analysts, resulting in their reporting not as accurately as it could otherwise be. These analysts, as opposed to third party analysts, tend to publish earnings forecasts that include smaller forecast errors and are less positive, while, nonetheless, are less accurate on the whole. Second, the same is also true among the most trusted financial analysts with solid reputations for being regarded as thorough and reliable in their reporting. The empirical analysis is made based on the assumption that an analyst’s opinion is influenced primarily by the characteristics of the financial investment services company where the analyst is working. In Korea financial investment services companies exert significant influence on their research function, and this seems to cause a COI. In other words, analysts reported more frequently if their securities firms had more brokerage business market share. That evidence was more clear when their securities firms had industrial affiliates. And in the middle-sized securities firm, their analysts reported more frequently if their securities firm had more investment banking business market share. Third, we found that the affiliated analysts could raise the COI by selecting more positive long-term IPO firms when their securities firm were affiliated with bank and asset management firms. Despite the recent move toward strengthening regulation in the financial sector, the frequent outbreaks of COI cases, within both domestic and foreign financial firms, reinforces the need for a stronger legal and institutional foundation to more effectively address the problem. Hopefully, the outcomes of this study will contribute to further improvement of financial investment services companies in their standards of work ethics in Korea, which will then raise the competitiveness of Korea’s financial industry as a whole. As domestic capital market grows and concentration and diversification of securities firms accelerate, accordingly, we conclude that strengthening the firewall among businesses of securities firms is imperative for the improvement of their competency and the prevention of investors' losses due to the COI.

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The global banking industry has undergone a wave of mergers over the last two decades and, as a result of which, mega banks have arisen in many countries around the world including Korea. Korean banks respond to this recent trend of bank consolidation by lowering the deposit interest rate and raising the loan interest rate (Park, 2004). Another major change had taken place even before the megabank trend. After the government allowed financial intermediation services by non-bank financial institutions in the late 1990s, commercial banks had started to reduce making loans to individual consumers since the monitoring costs are relatively higher than the interest income. As a result, banks have become more conservative in making loans to borrowers with low credit. In contrast to banks that strictly adhere to credit evaluation models, investors of online P2P (Peer-to-Peer) lending use much more flexible methods to judge borrowers’ qualifications for a loan, which include ‘hard information factors,’ ‘social interaction factors,’ and ‘soft information factors.’ Naturally, borrowers with low credit ratings use online P2P lending as one of the available funding sources. In this paper, we explore factors of success in online P2P lending repayment. In particular, this study examines how each of these three most common factors- ‘hard information factors’, ‘social interaction factors’, and ‘soft information factors’-- affect the loan repayment. This paper uses data from 542 loans from a leading crowd funding company in Korea from June 2008 through November 2010. We use a number of questions and answers, pre-poll results, and a number of attempts for making loans as the proxy variables of social interaction factors. Unlike foreign online P2P lending, Korea’s internet lending takes place through the social relationship between borrowers and investors, formed by communicating via the online bulletin board. We obtained the following empirical results. Firstly, borrowers’ personal bankruptcy experience has a significantly positive impact on the success of loan repayment. This is because borrowers with experience in personal bankruptcy have an incentive to improve their credit ratings through sincere loan repayment because a typical online P2P lending system uses a savings bank account as an escrow account. Therefore, they can improve their credit ratings for loans from commercial or savings banks by maintaining good credit standing online. These results imply that people with poor credit can use online P2P lending not only for raising money but also for improving their credit quality. Secondly, the purposes of loans for housing, living, and medical expenses have a significantly positive relationship with the success of loan repayment. This means that if they get loans for essential living expenses, they would exert greater efforts to repay the loans. Thirdly, debtors, who actively share personal information and interact with lenders online through P2P auction site message boards, are more likely to repay their loans than borrowers who have less social interaction. It appears that lenders can get more access to borrowers’ personal information and thus effectively monitor their loans. Borrowers can also establish trust with lenders and make a stronger effort to repay loans. The implications of our analysis are summarized as follows: Firstly, although earlier studies on personal loans have focused on personal bankruptcy decisions, this paper examines the effects of individual peculiarities on loan repayment. In particular, we find that bankrupt borrowers make greater efforts to repay the loans through online P2P lending. This is because if borrowers repay their loans in time, they can improve their overall credit ratings for loans from commercial banks in the future. Therefore, policy makers can consider online P2P lending as one of policy tools to encourage financial consumers with low credits for credit recovery. Secondly, we show that borrowers who raise money for essential living expenses make stronger efforts to repay their loans. Thirdly, we find that close interaction between potential borrowers and lenders is an important success factor in loan repayment. We conclude that such interaction can help reduce the information asymmetry, establish trust between borrowers and lenders, and raise the possibility of loan repayment. Our paper also has an important policy implication for consumer banking and small and medium enterprise finance. Domestic online P2P lending intermediaries work in partnership with savings banks and use their bank accounts as escrow accounts. However, due to the recent insolvencies of a number of large project finance operations, many savings banks are unable to play the roles of online P2P lending firms’ escrow accounts. For example, ‘Pop Funding’, one of the biggest online P2P lending intermediaries in Korea, had been in partnership with ‘Jeil Savings Bank’. But this bank was forced to shut down the operation because of its insolvency. Therefore, in order to firmly establish online P2P lending as a way to provide financing and credit enhancement for low credit borrowers, commercial banks should also play the role of providing escrow accounts for online P2P lending companies. In fact, European banks have recently been trying to enter the online P2P lending market more aggressively.

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This study analyzes potential economic effects the supply chain finance (SCF) framework may have on subcontract transactions using theoretical modeling and numerical analysis. The outcome of this study is expected to shed further light on more effective ways in which the supply chain finance (SCF) can be introduced in the market. This attempt aligns with the partnership with and shared growth between large and mid-sized companies, in the formation of a “win-win” market environment. Recently, the opportunity to optimize the financial flow in the whole supply chain processes between financial institutions and business enterprises has increased as most of the commercial transactions are being done through electronic system. This directly links the business flow externally to subcontractors and the like; the flow is no longer limited within the enterprise. This means that the number of targets to be optimized in the supply chain management (SCM) has exponentially increased. Accordingly, such extensive and complicated business ecosystem raises the impact supply chain finance (SCF) has on the businesses. Despite such rapid growth in electronic business transactions, the alternative payment method including electronic account receivables are rather limited. Although there have been some policy efforts to vitalize the electronic transactions, the channels are reserved to, for instance, buying companies and dealings with the companies’ tier 1 subcontractors whose credit ratings are relatively high. This evidently creates problems. For one thing, those subcontractors that belong to tier 2 or below in supply chain still very much at disadvantage in the current framework. When they have to liquidate their account receivables, they are but to choose between high discounted prices or an underground money market. On the other hand, more than 70% of the account receivables issued to tier 1 subcontractors are held up to maturity in the banking sector. To resolve this unfair practice, we propose a “win-win payment” system in subcontract transactions to mitigate difficulties faced by small and medium size companies. The system basically extends the reverse factoring mechanism for the sub-tier 1 enterprises. By granting credit supports to those smaller subcontractors, the system helps to decrease the cost of capital and create new incentive structures for suppliers to improve their quality. By so doing, the buyers can also expect to increase their sales and profits from the operation. This approach stands out from the previous studies that have mainly focused on the optimization of cost of capital at the level of the entire supply chain. We think that our approach better reflects the reality in view of the present domestic affairs. According to our analysis, the buying companies have an incentive to induce the suppliers to improve their quality by offering credits to the whole supply chain with the win-win spirit. With the expectation to raise the efficiency in supply chain management, they can also extend the deadlines of account payables, thereby increasing the expected profits as a result. However, we have verified that the system we had proposed operates only in the case in which the credit spread between buying and supplying companies exceeds a threshold. This may explain why the current system, a kind of reverse factoring with recourse only in two firms, is not working well between a buyer and its tier 1 subcontractors. We have also found that, in general, more credit is provided to the supplier whose quality has relatively higher impact on the market demand, which ultimately generates more expected profits. Further, we have proved that the business profits are maximized when the credit is offered to the tier 2 companies when the quality of tier 2 subcontractors has a decisive effect on the cost of the tier 1 firms. By adopting the new payment system, supplying companies are able to strengthen their financial solvency through decreasing the capital cost and holding period of the account receivables. And business continuity with the buyer can be stronger because of their quality improvement. Meanwhile, as for the financial institutions, they also have an incentive to participate the win-win payment system. They can acquire new customers without taking additional risks, often embedded in cross selling and lending. Ultimately, the benefit of the new system can be shared by all as the probability of fallouts in subcontract transactions can be reduced. Consequently, this can further strengthen the national economy as more tax revenues can be expected from commercial bills, which are to be curbed from the discounted underground market into the official banking sector. To make this system work, of course, a set of supportive policies from the government is required. For instance, various tax benefits and credit guarantees can be offered to the buying and supplying companies as rewards to adopting the new payment system in their business transactions. To induce the financial institutions to create more financial products to promote the system, the government can subsidize the expenses for the account receivable insurance. In addition, the watchdog’s thorough monitoring against buyers’ moral hazard is needed to ensure that the suppliers are free from the right of recourse.

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Korea Housing Finance Corporation (KHFC) introduced conforming mortgage loan (CML), which is standardized to be compatible with securitization. It is similar to the conforming loan in the U.S. The U.S. government is directly and indirectly involved in the home mortgage market. Its direct involvement is through the granting of Federal Housing Administration (FHA) loans, as well as loans granted by the Department of Veterans Affairs (VA) and the Rural Housing Service of the Department of Agriculture. The government’ indirect involvement is made possible through the securitization. The mortgage loans offered by private firms, on the other hand, are referred to as conventional mortgage loans. Some conventional mortgage loans have to conform to the requirements in order to be purchased by the Fannie Mae and the Freddie Mac. Most of these conforming loans are securitized by those public entities. By buying mortgage loans, these two governmentsponsored enterprises (GSEs) create liquidity for lenders, freeing up capital so they can make more loans, thereby offering better support to the credit market. The access to funding from the capital markets on fairly generous terms by Fannie Mae and Freddie Mac has historically generated a steady demand for conforming loans, and in the process allowed lenders to offer somewhat more favorable terms on these home mortgages. In many respects, CML in Korea and the conforming loan in the U.S. are quite similar. For instance, the private mortgage loans that satisfy the requirements set by KHFC are purchased by the corporation. CML also allows lenders to provide home mortgage loans on very favorable terms. KHFC requires the following specific conditions for CML. Borrowers should have credit grades no worse than 8th grade assigned by the certified credit bureaus. Loan-to-value and debt-to-income ratios should not violate the guidelines set by Korea’s financial watchdog, called the Financial Services Commission. Also, the loan size cannot exceed 500 million Korean Won, and the length of maturity ranges from five to thirty-five years. Both fixed and floating rate loans are accepted. In addition, there is no restriction on repayment method, and even bullet loans are qualified for CML. As soon as it was introduced in March 2012, due to these borrower-friendly terms, CML became instantly popular in the Korean residential mortgage loan market. Mainly its low interest rate and flexible repayment scheme attracted many. The low interest rate relies predominantly on the risk mitigation measure provided by KHFC since CMLs are sold by commercial banks with the presumption that they would be securitized through the issuance of MBS with credit guarantee by KHFC that is again backed by the government. The government guarantee of CMLs can be understood as a necessary incentive to induce mortgage borrowers to switch their existing loans to long-term fixed rate loans with amortization from short-term bullet loans. And yet, CML has some structural flaws that require immediate policy attention. Contrary to initial intention, bullet loans still comprise a significant portion of CML portfolio. In addition, the credit standard is set at a very low level in terms of the borrowers’ credit scores and repayment ability. Moreover, servicing companies are free to set their own level of servicing fees, which create ample chances for disputes to erupt between servicers and borrowers in anytime soon. These problems may result in significant financial burden on KHFC when they are entangled with the problem of information asymmetry prevalent in the mortgage market. In response to these potential challenges, we make the following four policy recommendations. First of all, bullet loans should be completely eliminated from CML portfolio. Second, credit standards should be significantly tightened immediately. Third, KHFC should restructure the loan management system to reclaim the right to determine the level of servicing fees lenders can charge. Finally, transparency on CML should be enhanced through disclosure of wider range of information and tighter monitoring by the financial supervisor and the National Assembly. According to the news reports in early 2013, a policy measure was taken to impose a ceiling on the amount of CML each bank can sell. Banks seemed to have responded to the measure by raising the loan interest rates. If the banks chose to increase the loan interest rate, one possible outcome is adverse selection. Safer borrowers whose risk levels fall within the given risk bracket may be unwilling to borrow at a higher interest rate than what their credit standing; as a result, the mix of borrowers within the pool becomes riskier. The second possibility is that an increase in the loan interest rate could worsen the likelihood for moral hazard problem. That is, those borrowers within the pool who have some latitude in their investment decisions may choose riskier projects at a higher loan interest rate. If the banks are exposed to the default risks, they will not raise the loan interest rates, because higher interest rates could mean lower expected profit for the banks. Since the banks are not responsible for the defaults, they are willing to raise the rates. Therefore, the quantity restriction should be avoided since it can only aggravate either adverse selection or moral hazard or both problems by those banks.

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