Sentiment or habits: Why not both?

Habits and sentiment are important psychological behaviors in asset pricing. In this article I nest consumer sentiment as a risk factor into the Campbell–Cochrane (CC) habit model and examine its impact on asset prices. The model provides an economic mechanism for the pricing of sentiment risk through its impact on habit sensitivity and equilibrium habit levels but finds its market price of risk much lower than fundamentals. The additional sentiment factor does not improve the CC model, with both models returning a matched moments error of $12\%$ from 1980Q1 to 2021Q4. The sentiment factor, however, subsumes risk aversion with a lower resulting risk coefficient than the CC model without sentiment. Furthermore, the model shows that during the COVID period, the risk premium was driven more by consumption growth than sentiment.     

Temperature and Growth: A Panel Analysis of the United States

We document that seasonal temperatures have significant and systematic effects on the U.S. economy, both at the aggregate level and across a wide cross section of economic sectors. This effect is particularly strong for the summer: a F increase in the average summer temperature is associated with a reduction in the annual growth rate of state‐level output of 0.15 to 0.25 percentage points. We combine our estimates with projected increases in seasonal temperatures and find that rising temperatures could reduce U.S. economic growth by up to one‐third over the next century.     

Optimal Mortgage Refinancing: A Closed‐Form Solution

We derive the first closed‐form optimal refinancing rule: refinance when the current mortgage interest rate falls below the original rate by at least In this formula W(.) is (the principal branch of) the Lambert W‐function, where ρ is the real discount rate, λ is the expected real rate of exogenous mortgage repayment, σ is the standard deviation of the mortgage rate, is the ratio of the tax‐adjusted refinancing cost and the remaining mortgage value, and τ is the marginal tax rate. This expression is derived by solving a tractable class of refinancing problems. Our quantitative results closely match those reported by researchers using numerical methods.     

Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads

This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events ${(\lambda }^{?})$, but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single‐factor model with ${\lambda }^{?}$ following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in ${\lambda }^{?}$ are found to be economically significant and co‐vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy.     

Internal Capital Markets in Business Groups: Evidence from the Asian Financial Crisis

This paper examines capital reallocation among firms in Korean business groups ( $chaebol$) in the aftermath of the 1997 Asian financial crisis, and the consequences of this capital reallocation for the investment and performance of $chaebol$ firms. We show that $chaebol$ transferred cash from low‐growth to high‐growth member firms, using cross‐firm equity investments. This capital reallocation allowed chaebol firms with greater investment opportunities to invest more than control firms after the crisis. These firms also showed higher profitability and lower declines in valuation than control firms following the crisis. Our results suggest that chaebol internal capital markets helped them mitigate the negative effects of the Asian crisis on investment and performance.     

An Alternative Testable Form of the Consumption CAPM

This paper develops a consumption-oriented model of asset prices in a multigood economy that is, in principle, testable even when aggregate consumption of goods and their market prices are only partially observable. Previous studies show that, when there are m consumption goods, equilibrium expected excess returns on securities are functions of their covariances with $m+1$ variables—aggregate consumption expenditure and market prices of consumption goods. Without making any further assumptions, the present model shows that a similar equilibrium relationship can be expressed in terms of covariances of asset returns with the following $m+1$ variables: market prices of k consumption goods and aggregate consumption of $m+1?k$ goods. Because the author's result provides researchers with some flexibility in choosing the set of $m+1$ variables that measure riskiness of securities, it should lead to more powerful tests of the model.     

Growth Opportunities and Risk-Taking by Financial Intermediaries

We show that growth opportunities which cannot be converted to cash under conditions of financial distress $\left(G_z\right)$ are a critical determinant of an intermediary's choice of risk. Financial institutions in which $G_z$ is a low proportion of total assets will be much more likely to engage in go-for-broke behavior. The model leads to a reevaluation of the effectiveness of several traditional remedies for dealing with banks that take excessive risks such as raising insurance premiums, intervening before capital is depleted, and restricting investment options. The model also has implications about a new approach to the examination of financial intermediaries.     

A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market

In an efficient market, the fundamental value of a security fluctuates randomly. However, trading costs induce negative serial dependence in successive observed market price changes. In fact, given market efficiency, the effective bid-ask spread can be measured by $\text{Spread}=2\sqrt{?\text{cov}}$ where “cov” is the first-order serial covariance of price changes. This implicit measure of the bid-ask spread is derived formally and is shown empirically to be closely related to firm size.     

A Theoretical Framework for Evaluating the Impact of Universal Reserve Requirements

This paper provides an appropriate framework to evaluate the impact of the universal reserve requirements called for by the new DIDMC Act of 1980. We derived the optimal reserve ratios for a dual banking system under the objective of controlling the monetary aggregates and the level of output. Then optimal reserve requirements were calculated from illustrative money market and macroeconomic parameters since the usual comparative statics were not useful. The results, generally, suggested optimal reserve ratios which were significantly higher than the old dual or the new universal reserve regimes for all targets. However, the calculation of values for the loss functions under various reserve regimes suggests that attainment of $r_1^{*},r_2^{*}$ and $t^{*}$ may not be imperative, since the discrepancy between losses for optimal and various nonoptimal reserve schemes were not large. A major result of this paper, observed for both monetary and real targets, was that the differences in the instability of the targets for the old dual reserve ratios and the Fed's new universal reserve scheme were small. This result clearly suggests that although the DIDMC Act may solve the Federal Reserve's membership problem, it will not significantly enhance the Fed's effectiveness in controlling monetary or real sector aggregates.     

Reassessing False Discoveries in Mutual Fund Performance: Skill,Luck, or Lack of Power?

Barras, Scaillet, and Wermers propose the false discovery rate (FDR) to separate skill (alpha) from luck in fund performance. Using simulations with parameters informed by the data, we find that this methodology is conservative and underestimates the proportion of nonzero‐alpha funds. For example, 65% of funds with economically large alphas of $\pm 2\%$ are misclassified as zero alpha. This bias arises from the low signal‐to‐noise ratio in fund returns and the resulting low statistical power. Our results question FDR's applicability in performance evaluation and other domains with low power, and can materially change the conclusion that most funds have zero alpha.     

On the Effects of Barriers to International Investment

A simple model is presented in which it is costly for domestic investors to hold foreign assets. The implications of the model for the composition of optimal portfolios at home and abroad are derived. It is shown that all foreign assets with a beta larger than some beta ${\beta }^{*}$ plot on either one of two security market lines. Some foreign assets with a beta smaller than ${\beta }^{*}$ are not held by domestic investors even if their expected return is increased slightly.     

R2

Even with hindsight, the ability to explain stock price changes is modest. $R^2$s were calculated for the returns of large stocks as explained by systematic economic influences, by the returns on other stocks in the same industry, and by public firm-specific news events. The average adjusted $R^2$ is only about .35 with monthly data and .20 with daily data. There is little relation between explanatory power and either the firm's size or its industry. There is little improvement in $R^2$ from eliminating all dates surrounding news reports in the financial press. However, the sample kurtosis is quite different when such news events are eliminated, thereby revealing a mixture of return distributions. Non-news dates also indicate the presence of a distributional mixture, perhaps due to traders acting on private information.