Rare events and annuity market participation

We investigate whether a rare event (like the default of the annuity provider) can explain the annuity market participation puzzle. High risk aversion is needed to change behavior in the presence of such a disastrous shock but higher risk aversion also makes annuities more valuable. Therefore, these rare events are unlikely candidates to explain the low take-up of voluntary annuities: the conclusion is robust to disentangling risk aversion from intertemporal substitution and to allowing portfolio investment in a stock market index.     

Does liquidity drive stock market returns? The role of investor risk aversion

In this paper, we explore the relations between liquidity, stock returns, and investor risk aversion as captured by the variance risk premium (VRP). This is motivated by theoretical and empirical evidence in the literature which suggests that investor risk aversion negatively correlates with asset liquidity, and ample empirical evidence documenting liquidity risk premium. We use monthly US data from January 1999 to December 2018 and show that innovations in the VRP Granger-cause stock returns, which in turn drive liquidity. Our findings are consistent with predictions of prior theories and highlight the predictability of the VRP. They also contribute to the on-going debate on the causal relation between stock returns and liquidity. Finally, we explore the channels through which the VRP impacts liquidity and find that the VRP influences market and momentum factors, and that movements in these factors lead to changes in liquidity.

     

Inflation Uncertainty, Real-Interest-Rate Uncertainty, and the Liquidity Premium on Government Bonds

This paper shows that the components of uncertainty about nominal interest rates, real-rate uncertainty and inflation uncertainty, have different effects on the liquidity premium. An increase in inflation uncertainty should increase the equilibrium liquidity premium because investors reduce the effect of inflation uncertainty on the riskiness of their portfolios by holding more short-term bonds. In contrast, an investor can reduce the effects of uncertainty about future ex-ante real rates on portfolio return by matching more closely the maturity dates of the bonds held with the date on which the portfolio is to be liquidated for consumption purposes. Thus, the effect of an increase in real-rate uncertainty on the equilibrium liquidity premium is ambiguous, depending on the relative magnitudes of long-term and short-term saving and the proportions of short-term and long-term bonds issued by the government.     

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short‐selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short‐sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive‐net‐supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.     

The pricing of systematic liquidity risk: Empirical evidence from the US stock market

In this study, we examine whether aggregate market liquidity risk is priced in the US stock market. We define a bivariate Garch (1,1)-in-mean specification for the market portfolio excess returns and the changes in the standardized number of shares in the S&P 500 Index, the aggregate market liquidity proxy. The findings, based on monthly data, suggest that systematic liquidity risk is priced in the US over the period January 1973–December 1997. The liquidity premium represents a non-negligible, negative and time-varying component of the total market risk premium whose magnitude is not influenced by the October’87 Crash.     

What do asset prices have to say about risk appetite and uncertainty?

Building on intuition from the dynamic asset pricing literature, we uncover unobserved risk aversion and fundamental uncertainty from the observed time series of the variance premium and the credit spread while controlling for the conditional variance of stock returns, expectations about the macroeconomic outlook, and interest rates. We apply this methodology to monthly data from both Germany and the US. We find that the variance premium contains a substantial amount of information about risk aversion whereas the credit spread has a lot to say about uncertainty. We link our risk aversion and uncertainty estimates to practitioner and “academic” risk aversion indices, sentiment indices, financial stress indices, business cycle indicators and liquidity measures.     

Age‐Dependent Increasing Risk Aversion and the Equity Premium Puzzle

We introduce a new preference structure—age‐dependent increasing risk aversion (IRA)—in a three‐period overlapping generations model with borrowing constraints, and examine the behavior of equity premium in this framework. We find that IRA preferences generate results that are more consistent with U.S. data for the equity premium, level of savings and portfolio shares, without assuming unreasonable levels of risk aversion. We find that the relative difference between the two risk aversions (how much more risk‐averse old agents are relative to the middle‐aged) matters more than the average risk aversion in the economy (how much more risk‐averse both cohorts are). Our findings are robust with respect to a number of model generalizations.     

Luxury Goods and the Equity Premium

This paper evaluates the equity premium using novel data on the consumption of luxury goods. Specifying utility as a nonhomothetic function of both luxury and basic consumption goods, we derive pricing equations and evaluate the risk of holding equity. Household survey and national accounts data mostly reflect basic consumption, and therefore overstate the risk aversion necessary to match the observed equity premium. The risk aversion implied by the consumption of luxury goods is more than an order of magnitude less than that implied by national accounts data. For the very rich, the equity premium is much less of a puzzle.     

Liquidity risk and stock returns around the world

The recent global financial crisis demonstrates that market liquidity is a prominent systematic risk globally. We find that local liquidity risk, in addition to the local market, value and size factors, demands a systematic premium across stocks in 11 developed markets. This local pricing premium is smaller in countries where the country-level corporate boards are more effective and where there are less insider trading activities. We also discover that global liquidity risk is a significant pricing factor across all developed country market portfolios after controlling for global market, value, and size factors. The contribution of this risk to the return on a country market portfolio is economically and statistically significant within and across regions.     

Optimal commodity asset allocation with a coherent market risk modeling

This paper fills a fundamental gap in commodity price risk management and optimal portfolio selection literatures by contributing a thorough reflection on trading risk modeling with a dynamic asset allocation process and under the supposition of illiquid and adverse market settings. This paper analyzes, from a portfolio managers' perspective, the performance of liquidity adjusted risk modeling in obtaining efficient and coherent investable commodity portfolios under normal and adverse market conditions. As such, the author argues that liquidity risk associated with the uncertainty of liquidating multiple commodity assets over given holding periods is a key factor in formalizing and measuring overall trading risk and is thus an important component to model, particularly in the wake of the repercussions of the recent 2008 financial crisis. To this end, this article proposes a practical technique for the quantification of liquidity trading risk for large portfolios that consist of multiple commodity assets and whereby the holding periods are adjusted according to the specific needs of each trading portfolio. Specifically, the paper proposes a robust technique to commodity optimal portfolio selection, in a liquidity-adjusted value-at-risk (L-VaR) framework, and particularly from the perspective of large portfolios that have both long and short positions or portfolios that consist of merely pure long trading positions. Moreover, in this paper, the author develops a portfolio selection model and an optimization-algorithm which allocates commodity assets by minimizing the L-VaR subject to applying credible operational and financial constraints based on fundamental asset management considerations. The empirical optimization results indicate that this alternate L-VaR technique can be regarded as a robust portfolio management tool and can have many uses and applications in real-world asset management practices and predominantly for fund managers with large commodity portfolios.     

A theoretical analysis of the liquidity risk premium embedded in the prices of voting and non-voting stocks

Liquidity risk and corporate control considerations affect shareholders' willingness to invest in stocks and should thus be reflected in their prices. This paper derives the premium required by liquidity risk-averse agents who invest, respectively in non-voting and voting shares. It is shown that the liquidity risk premium depends upon the investor's risk aversion, the variance of his future consumption flow and the liquidation probability of each share type. Furthermore, liquidity risk premia depend upon the firm's capital structure decisions, the distribution and private valuation of voting rights by its shareholders.     

Loss aversion,asymmetric market comovements,and the home bias

Loss aversion has been used to explain why a high equity premium might be consistent with plausible levels of risk aversion. The intuition is that the first-order-different utility impact of wealth gains and losses leads loss-averse investors to behave similarly to investors with high risk aversion. But if so, should those agents not perceive larger gains from international diversification than standard expected-utility investors with plausible levels of risk aversion? They might not, because comovements in international stock markets are asymmetric: correlations are higher in market downturns than in upturns. This asymmetry dampens the gains from diversification relatively more for loss-averse investors. We analyze the portfolio problem of such an investor who has to choose between home and foreign equities in the presence of asymmetric comovement in returns. Perhaps surprisingly, in the context of the home bias puzzle we find that loss-averse investors behave similarly to those with standard expected-utility preferences and plausible levels of risk aversion. We argue that preference specifications that appear to perform well with respect to the equity premium puzzle should be subjected to this “test”.     

The effect of temporal risk aversion on liquidity preference

In most instances, investors are not indifferent to risk. Their attitudes toward it influence their decisions. Temporal risk aversion, the dynamic analogue of the usual concept of risk aversion, has a marked effect on investors' decisions but is usually ignored in the literature. This paper investigates the liquidity preference of temporally risk-averse investors. The analysis shows that, all other things being equal, temporal risk aversion reduces the liquidity premium investors must receive to hold an asset that is not perfectly reversible. Thus, the optimal investment policy is closer to what one would expect had a frictionless exchange market existed for the irreversible asset. As far as an individual's investment behavior is concerned, temporal risk aversion counters the effects of an asset's irreversibility and tends to compensate for the absence of frictionless exchange.     

Liquidity and conditional portfolio choice: A nonparametric investigation

This paper studies the relation between liquidity and optimal portfolio allocations. Given that the portfolio problem of a constant relative risk aversion investor does not have a closed-form solution, we use a nonparametric approach to estimate the optimal allocations. Using a sample of NYSE stocks from 1963–2000, we find that the optimal portfolio weight in small stocks is strongly increasing in liquidity at short daily and weekly horizons. This result is consistent for three different measures of liquidity: price impact, dollar volume, and turnover. However, liquidity does not influence the optimal portfolio choice for large stocks, nor for longer monthly investment horizons.     

Dynamic portfolio optimization with liquidity cost and market impact: a simulation-and-regression approach

We present a simulation-and-regression method for solving dynamic portfolio optimization problems in the presence of general transaction costs, liquidity costs and market impact. This method extends the classical least squares Monte Carlo algorithm to incorporate switching costs, corresponding to transaction costs and transient liquidity costs, as well as multiple endogenous state variables, namely the portfolio value and the asset prices subject to permanent market impact. To handle endogenous state variables, we adapt a control randomization approach to portfolio optimization problems and further improve the numerical accuracy of this technique for the case of discrete controls. We validate our modified numerical method by solving a realistic cash-and-stock portfolio with a power-law liquidity model. We identify the certainty equivalent losses associated with ignoring liquidity effects, and illustrate how our dynamic optimization method protects the investor's capital under illiquid market conditions. Lastly, we analyze, under different liquidity conditions, the sensitivities of certainty equivalent returns and optimal allocations with respect to trading volume, stock price volatility, initial investment amount, risk aversion level and investment horizon.     

A Model of International Asset Pricing with a Constraint on the Foreign Equity Ownership

This paper derives a closed-form valuation model in a two-country world in which the domestic investors are constrained to own at most a fraction, δ, of the number of shares outstanding of the foreign firms. When the “δ constraint” is binding, two different prices rule in the foreign securities market, reflecting the premium offered by the domestic investors over the price under no constraints and the discount demanded by the foreign investors. The premium is shown to be a multiple of the discount, the multiple being the ratio of the aggregate risk aversion of the domestic and foreign investors. Given the aggregate risk-aversion parameters, the equilibrium premium and discount are determined by the severity of the δ constraint and the “pure” foreign market risk.     

Disappointment aversion and the equity premium puzzle: new international evidence

Drawing upon the seminal study of Ang, Bekaert, and Liu [2005. “Why Stock May Disappoint?” Journal of Financial Economics 76 (3): 471–508], we incorporate disappointment aversion (DA, that is, aversion to outcomes that are worse than prior expectations) within a simple theoretical portfolio-choice model. Based on the results of this model, we then empirically address the portfolio allocation problem of an investor who chooses between a risky and a risk-free asset using international data from 19 countries. Our findings strongly support the view that DA leads investors to reduce their exposure to the stock market (i.e. DA significantly depresses the portfolio weights on equities in all cases considered). Overall, our study shows that in addition to risk aversion, DA plays an important role in explaining the equity premium puzzle around the world.     

Transaction costs, trading volume, and the liquidity premium

In a market with one safe and one risky asset, an investor with a long horizon, constant investment opportunities and constant relative risk aversion trades with small proportional transaction costs. We derive explicit formulas for the optimal investment policy, its implied welfare, liquidity premium, and trading volume. At the first order, the liquidity premium equals the spread, times share turnover, times a universal constant. The results are robust to consumption and finite horizons. We exploit the equivalence of the transaction cost market to another frictionless market, with a shadow risky asset, in which investment opportunities are stochastic. The shadow price is also found explicitly.     

A Model of Monetary Policy and Risk Premia

We develop a dynamic asset pricing model in which monetary policy affects the risk premium component of the cost of capital. Risk‐tolerant agents (banks) borrow from risk‐averse agents (i.e., take deposits) to fund levered investments. Leverage exposes banks to funding risk, which they insure by holding liquidity buffers. By changing the nominal rate the central bank influences the liquidity premium, and hence the cost of taking leverage. Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices, volatility, investment, and growth. We analyze forward guidance, a “Greenspan put,” and the yield curve.     

The systematic pricing of market sentiment shock

ABSTRACT

We show that market sentiment shocks create demand shocks for risky assets and a systematic risk for assets. We measure a market sentiment shock as the unexpected portion of the University of Michigan Consumer Sentiment Index’s growth. This shock prices stock returns in arbitrage pricing theory framework at 1% after controlling for market, size, value, momentum, and liquidity risk factors. Its premium lowered the implied risk aversion by 97.9% to 11.46 between 1978 and 2009 in our sentiment consumption-based capital-asset-pricing model. Merton’s [1973. “An Intertemporal Capital Asset Pricing Model.” Econometrica 41: 867–887]. intertemporal capital-asset-pricing model reconfirms our finding that this market sentiment shock is a systematic risk factor that provides investment opportunities.