What is the impact of wealth shocks on asset allocation?

I test the assumption of constant relative risk aversion using U.S. macroeconomic data and analyse the role of wealth shocks in generating transitory changes in asset portfolio composition. I show that the risky asset share exhibits cyclical behavior and it is significantly (and positively) affected by unexpected variation in wealth. Therefore, the empirical evidence suggests that risk aversion is counter-cyclical. I also find that the portfolio share of housing wealth falls when the agent is faced with a positive wealth shock, i.e. housing is a hedge against unfavorable wealth fluctuations. Finally, considering a variety of wealth definitions, the results show that: (i) wealth effects are stronger for direct holdings of risky assets than for indirect holdings, which highlights that investors do not typically trade some assets such as pension or mutual funds; (ii) although significant, wealth effects on asset allocation are mainly temporary as agents quickly rebalance the asset portfolio composition (i.e. there is weak evidence of inertia or slow adjustment in asset allocation); and (iii) changes in expected returns partially explain the variation in risky asset allocation.     

Portfolio choice in retirement: Health risk and the demand for annuities,housing, and risky assets

In a life-cycle model, a retiree faces stochastic health depreciation and chooses consumption, health expenditure, and the allocation of wealth between bonds, stocks, and housing. The model explains key facts about asset allocation and health expenditure across health status and age. The portfolio share in stocks is low overall and is positively related to health, especially for younger retirees. The portfolio share in housing is negatively related to health for younger retirees and falls significantly in age. Finally, out-of-pocket health expenditure as a share of income is negatively related to health and rises in age.     

The impact of international portfolio composition on consumption risk sharing

Recent empirical work has shown that ongoing international financial integration facilitates cross-country consumption risk sharing. These studies typically find that countries with high equity home bias exhibit relatively low international consumption risk sharing. We extend this line of research and demonstrate that it is not only a country's equity home bias that prevents consumption risk sharing. In addition, the composition of a country's foreign asset portfolio plays an important role. Using panel-data regression for a group of OECD countries over the period 1980–2007, we show that foreign investment bias has additional explanatory power for consumption risk sharing.     

A general equilibrium model of housing consumption and investment

This article develops an applied general equilibrium model for analyzing the effects of tax policy on housing consumption and investment. The model incorporates housing tenure choice and consumption decisions in an explicit model of household portfolio choice that recognizes that the demand for owner-occupied housing depends on the after-tax returns from housing capital and other investments. Asset returns are stochastic so that asset holdings are determined by the desired risk-return relationships of households. Owner-occupied housing has a unique position because it has both a consumption role in providing housing services and an investment role. The model is then used to evaluate the effects of tax policy on the size and composition of the housing stock. Potential tax changes include a flat rate income tax and taxation of the imputed rent from owner-occupied housing.     

Asset allocation and location over the life cycle with investment-linked survival-contingent payouts

This paper shows how survival-contingent investment-linked payouts can enhance investor wellbeing in the context of a portfolio choice model which integrates uninsurable labor income and asymmetric mortality expectations. In exchange for illiquidity, these products provide the consumer with access to mutual-fund style portfolio choice, as well as the survival credit generated from pooling mortality risk. Our model generates optimal asset location patterns indicating how much to hold in liquid versus illiquid survival-contingent payouts over the lifetime, and also asset allocation paths, showing how to invest in stocks versus bonds. We show that the investor who moves her money out of liquid saving into survival-contingent assets gradually from middle age to retirement and beyond, will enhance her welfare by as much as 50%. The results are robust to the introduction of uninsurable consumption shocks in housing expenses, income flows during the worklife and retirement, sudden changes in health status, and medical expenses.     

Composition of wealth,conditioning information,and the cross-section of stock returns

Value stocks covary with aggregate consumption more than growth stocks during periods when financial wealth is low relative to consumption. However, the conditional value premium does not exhibit such countercyclical behavior. Consequently, a one-factor conditional consumption-based asset pricing model can be rejected without making any arbitrary assumptions on the dynamics of the price of risk or the conditional moments. Empirical evidence is somewhat more consistent with a consumption-based model augmented with an aggregate wealth growth factor, which can be motivated by either recursive preferences or relative wealth concerns.     

What makes a bank risky? Insights from the optimal capital structure of banks

Assessing the risk of bank failures is the paramount concern of bank regulation. This paper argues that in order to assess the default risk of a bank, it is important to consider its financing decisions as an endogenous dynamic process. We provide a continuous-time model, where banks choose the deposit volume in order to trade off the benefits of earning deposit premiums against the costs that occur at future capital structure adjustments. The bank’s asset value may suffer from shocks and follows a jump-diffusion process.     

Capital Share Risk in U.S. Asset Pricing

A single macroeconomic factor based on growth in the capital share of aggregate income exhibits significant explanatory power for expected returns across a range of equity characteristic portfolios and nonequity asset classes, with risk price estimates that are of the same sign and similar in magnitude. Positive exposure to capital share risk earns a positive risk premium, commensurate with recent asset pricing models in which redistributive shocks shift the share of income between the wealthy, who finance consumption primarily out of asset ownership, and workers, who finance consumption primarily out of wages and salaries.     

Housing Collateral, Consumption Insurance, and Risk Premia: An Empirical Perspective

In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the United States, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains 80% of the cross‐sectional variation in annual size and book‐to‐market portfolio returns.     

Efficient portfolios when housing needs change over the life cycle

We address the issue of the efficiency of household portfolios in the presence of housing risk. We treat housing stock as an asset and rents as a stochastic liability stream: over the life cycle, households can be short or long in their net-housing position. Efficient financial portfolios are the sum of a standard Markowitz portfolio and a housing risk hedge term that multiplies net housing wealth. Our empirical results show that net housing plays a key role in determining which household portfolios are inefficient. The largest proportion of inefficient portfolios obtains among those with positive net housing, who should invest more in stocks.     

Ownership structure,risk and performance in the European banking industry

We compare the performance and risk of a sample of 181 large banks from 15 European countries over the 1999–2004 period and evaluate the impact of alternative ownership models, together with the degree of ownership concentration, on their profitability, cost efficiency and risk. Three main results emerge. First, after controlling for bank characteristics, country and time effects, mutual banks and government-owned banks exhibit a lower profitability than privately owned banks, in spite of their lower costs. Second, public sector banks have poorer loan quality and higher insolvency risk than other types of banks while mutual banks have better loan quality and lower asset risk than both private and public sector banks. Finally, while ownership concentration does not significantly affect a bank’s profitability, a higher ownership concentration is associated with better loan quality, lower asset risk and lower insolvency risk. These differences, along with differences in asset composition and funding mix, indicate a different financial intermediation model for the different ownership forms.     

Risk,uncertainty, and asset prices

We identify the relative importance of changes in the conditional variance of fundamentals (which we call “uncertainty”) and changes in risk aversion in the determination of the term structure, equity prices, and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in price–dividend ratios and the equity risk premium is primarily driven by risk aversion, uncertainty plays a large role in the term structure and is the driver of countercyclical volatility of asset returns.     

Risk and return in residential spatial markets: An empiric and theoretic model

The paper is concerned with price and rent fluctuations in predominantly owner-occupied residental real estate. It presents the owner-occupier household as a housing consumer as well as an investor. It conjectures that since risk and return are known to be positively related in financial markets, they might also be thus related in residential real estate markets. If that is so, neighborhoods that are known to yield high returns will be the ones less price and rent stable than low yielding ones.The Capital Asset Pricing Model is not helpful in explaining a possible risk/return relationship in housing markets. Its major assumption about portfolio diversification is contrary to the nature of owner-occupied residential real estate. An owner occupier household, by definition, holds one unit of the asset and acts simultaneously as an investor and consumer of housing. For the capital market investor, investment and consumption decisions are separable. Therefore, a new theoretical model of consumer choice is proposed. Tel-Aviv price and rent data during a volatile market period are used for testing the main risk/return conjecture as well as other related hypotheses stemming from the model. The findings lend support to the conjecture and shed light on possible spatial determinants of owners' risk.     

Liquidity Risk of Private Assets: Evidence from Real Estate Markets

Investment in thinly traded private assets involves liquidity risk. Existing literature provides limited guidance as it mainly focuses on publicly traded security assets such as stocks and bonds. This paper develops an analytical tool for quantifying liquidity risk of private assets. Using commercial real estate as a model asset and under reasonable assumptions, we find that the magnitude of liquidity risk is too large to be ignored, especially in down markets when liquidity risk is a great concern.     

Future labor income growth and the cross-section of equity returns

This paper examines the equilibrium relation between future labor income growth and expected asset returns; it proposes revisions in the expectation of future labor income growth as a macroeconomic state variable and suggests a three-factor model, including a factor related to this variable, along with the consumption growth factor and the market factor. The proposed future labor income growth factor is positively associated with the Fama-French factors and subsumes their explanatory power in explaining the cross-section of stock returns. These results provide a possible economic explanation for the roles of the Fama-French factors: they are compensation for higher exposure to the risk related to changes in the value of human capital. This paper also compares the performance of the proposed three-factor model with other competing models and finds that the proposed model specification better captures cross-sectional variation in average returns than any of the competing asset pricing models considered.     

Conditional risk premia in currency markets and other asset classes

The downside risk capital asset pricing model (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly rationalize the cross section of equity, equity index options, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.     

Banking Competition,Collateral Constraints,and Optimal Monetary Policy

We analyze optimal monetary policy in a model with two distinct financial frictions: monopolistically competitive banks that charge endogenous lending spreads, and collateral constraints. We show that welfare maximization is equivalent to stabilization of four goals: inflation, output gap, the “consumption gap” between borrowers and savers, and a “housing gap” that measures the distortion in the distribution of the collateralizable asset between both groups. Collateral constraints create a trade‐off between stabilization goals. Following both productivity and financial shocks, and relative to strict inflation targeting, the optimal policy implies sharper movements in the policy rate, aimed primarily at reducing fluctuations in asset prices and hence in borrowers' net worth. The policy trade‐offs become amplified as banking competition increases, due to the fall in lending spreads and the resulting increase in borrowers' leverage.     

Asset pricing with heterogeneous beliefs and relative performance

We propose an equilibrium asset pricing model in which agents with heterogeneous beliefs care about relative performance. We find that the concern with relative performance leads agents to trade more similarly, a development that has two effects. First, similar trading directly decreases volatility. Second, similar trading decreases the impact of dominant agents. The second effect dominates the first when agents expect large differences between their final performances, and vice versa when agents expect small differences between their final performances. Compared with the case in which agents are unconcerned about relative performance, the stock return volatility is higher when the second effect dominates, and lower when the first effect dominates. This paper also demonstrates that the concern about relative performance influences investors’ holdings, stock prices and risk premia.     

Pricing innovations in consumption growth: A re-evaluation of the recursive utility model

We re-evaluate the cross-sectional asset pricing implications of the recursive utility function of  and , using innovations in future consumption growth in our tests. Our empirical specification helps explain the size, value and momentum effects. Specifically, we find that (?) the beta associated with news about consumption growth has a systematic pattern: beta decreases along the size dimension and increases along the book-to-market and momentum dimensions, (??) innovation in consumption growth is significantly priced in asset returns using both the Fama and MacBeth (1973) and the stochastic discount factor approaches, and (???) the model performs better than both the CAPM and Fama–French model.     

The Epstein–Zin Model with Liquidity Extension

In this paper, we extend the Epstein–Zin model with liquidity risk and assess the extended model's performance against the traditional consumption pricing models. We show that liquidity is a significant risk factor, and it adds considerable explanatory power to the model. The liquidity‐extended model produces both a higher cross‐sectional R² and a smaller Hansen and Jagannathan distance than the traditional consumption‐based capital‐asset pricing model and the original Epstein–Zin model. Overall, we show that liquidity is both a priced factor and a key contributor to the extended Epstein–Zin model's goodness‐of‐fit.