Uncertainty,Inflation, and Welfare

This paper studies the welfare costs and the redistributive effects of inflation in the presence of idiosyncratic liquidity risk, in a microfounded search‐theoretical monetary model. We calibrate the model to match the empirical aggregate money demand and the distribution of money holdings across households and study the effects of inflation under the implied degree of market incompleteness. We show that in the presence of imperfect insurance the estimated long‐run welfare costs of inflation are on average 40% to 55% smaller compared to a complete markets, representative agent economy, and that inflation induces important redistributive effects across households.     

Time-varying idiosyncratic risk and aggregate consumption dynamics

Long-term earnings losses for displaced workers are large and counter-cyclical. Similarly, the skewness of earnings growth rates is strongly pro-cyclical. This paper presents an incomplete markets business cycle model in which idiosyncratic risk varies over time in accordance with these empirical findings. These dynamics of idiosyncratic risk give rise to a cyclical precautionary savings motive that substantially raises the volatility of aggregate consumption growth. According to the model, idiosyncratic risk spiked during the Great Recession, leading to a substantial decline in aggregate consumption.     

A new approach to measuring riskiness in the equity market: Implications for the risk premium

We introduce a new approach to measuring riskiness in the equity market. We propose option implied and physical measures of riskiness and investigate their performance in predicting future market returns. The predictive regressions indicate a positive and significant relation between time-varying riskiness and expected market returns. The significantly positive link between aggregate riskiness and market risk premium remains intact after controlling for the S&P 500 index option implied volatility (VIX), aggregate idiosyncratic volatility, and a large set of macroeconomic variables. We also provide alternative explanations for the positive relation by showing that aggregate riskiness is higher during economic downturns characterized by high aggregate risk aversion and high expected returns.     

Investment,idiosyncratic risk,and growth options

We provide evidence that growth options play an important role in determining the negative relation between corporate investment and idiosyncratic risk in the absence of agency problem. A simple real options model predicts that the negative relation between corporate investment and idiosyncratic risk is a U-shaped function of the level of idiosyncratic risk: investment responds the most when idiosyncratic risk is at the intermediate level. And the negative relation is stronger when firms possess more growth options. Our results are robust when we control for the effect of managerial risk aversion, supporting the view that firms’ optimal response to uncertainty is an important driving force behind the negative investment–idiosyncratic risk relation.     

Habit-based asset pricing with limited participation consumption

We calibrate and estimate a consumption-based asset pricing model with habit formation using limited participation consumption data. Based on survey data of a representative sample of American households, we distinguish between assetholder and non-assetholder consumption, as well as the standard aggregate consumption series commonly used in the CCAPM literature. We show that assetholder consumption outperforms non-assetholder and aggregate consumption data in explaining bond returns, bond yields, and the volatility of bond yields. We further show that the high volatility of assetholder consumption enables the model to explain the equity premium puzzle and the risk-free rate puzzle simultaneously for a reasonable value of relative risk aversion.     

Risk Attitude and Housing Wealth Effect

This paper examines whether the housing wealth effect—the consumption change induced by house price appreciation is dependent upon households’ attitudes toward risk. A simple theoretical model is introduced to highlight a negative relationship between the wealth effect and risk aversion. The paper empirically tests for this negative relationship, using data from the U.S. Consumer Expenditure Survey. The investigation involves two steps. In the first step, we make use of households’ demographics and their risky and liquid asset holdings to estimate risk aversion. The Heckman correction model is applied to address the issue of limited stock market participation. For the second step, we construct pseudo panel data through grouping households by their birth years and their predicted values of risk aversion, and then, we estimate the responses of households’ consumption changes to house price fluctuations by risk-attitude group. Consistent with the prediction of the theoretical model, the estimation results suggest a significant negative relationship between the housing wealth effect and households’ risk attitudes. Households, who are less risk averse, experience greater consumption changes in response to house price appreciation.     

Risk aversion, intertemporal substitution, and the aggregate investment-uncertainty relationship

We analyze the role of risk aversion and intertemporal substitution in a simple dynamic general equilibrium model of investment and savings. Our main finding is that risk aversion cannot by itself explain a negative relationship between aggregate investment and aggregate uncertainty, as the effect of increased uncertainty on investment also depends on the intertemporal elasticity of substitution. In particular, the relationship between aggregate investment and aggregate uncertainty is positive even if agents are very risk averse, as long as the elasticity of intertemporal substitution is low. A negative investment-uncertainty relationship requires that the relative risk aversion and the elasticity of intertemporal substitution are both relatively high or both relatively low. We also show that the implications of our model are consistent with the available empirical evidence.     

Counterparty risk,central counterparty clearing and aggregate risk

I construct a model of bilateral trading of over-the-counter (OTC) derivatives to study the performance of central counterparty (CCP) clearing. I first show how buyers are exposed to counterparty risk under bilateral clearing. I then show how a CCP can fully insure against counterparty risk through risk-mutualization and achieve full idiosyncratic risk-sharing among market participants. I further demonstrate the impact of aggregate risk on CCP clearing and illustrate a scenario in which the CCP fails to provide full insurance against counterparty risk and full idiosyncratic risk-sharing collapses under severe aggregate risk. To insure against aggregate risk and retain full idiosyncratic risk-sharing, sellers’ capital resource is important on top of CCP mutualization. Finally, I allow buyers to costly search for sellers and study the implications of optimal search effort. I show how a moral hazard problem can arise if effort is unobservable, in which case full CCP insurance against counterparty risk is no longer optimal.     

A Utility-Based Model of Common Stock Price Movements

This paper develops and tests a nonlinear utility-based econometric model of the temporal behavior of aggregate stock price movements based on a constant relative risk aversion utility function and an observable information set consisting of aggregate consumption, aggregate dividends, and past stock prices. The stochastic process derived from time-series analyses of consumption and dividends measured over annual intervals is used to derive and empirically test a closed-form solution for stock-price movements. The endogenization of discount rate changes in the utility-based model is shown to be more consistent with aggregate stock price movements over a twenty-year holdout period than constant discount rate models. The model is also used to estimate the representative investor's relative risk aversion. The estimate of 4.22 is consistent with that used by Grossman and Shiller in their perfect foresight model and is significantly higher than the relative risk aversion of 1.0 implied by logarithmic utility.     

An Equilibrium Model of Asset Pricing and Moral Hazard

This article develops an integrated model of asset pricing andmoral hazard. It is demonstrated that the expected dollar returnof a stock is independent of managerial incentives and idiosyncraticrisk, but the equilibrium price of the stock depends on them.Thus, the expected rate of return is affected by managerialincentives and idiosyncratic risk. It is shown, however, thatmanagerial incentives and idiosyncratic risk affect the expectedrate of return through their influence on systematic risk ratherthan serve as independent risk factors. It is also shown thatthe risk aversion of the principal in the model leads to lessemphasis on relative performance evaluation than in a modelwith a risk-neutral principal.     

The Cross-Section of Volatility and Expected Returns

We examine the pricing of aggregate volatility risk in the cross‐section of stock returns. Consistent with theory, we find that stocks with high sensitivities to innovations in aggregate volatility have low average returns. Stocks with high idiosyncratic volatility relative to the Fama and French (1993, Journal of Financial Economics 25, 2349) model have abysmally low average returns. This phenomenon cannot be explained by exposure to aggregate volatility risk. Size, book‐to‐market, momentum, and liquidity effects cannot account for either the low average returns earned by stocks with high exposure to systematic volatility risk or for the low average returns of stocks with high idiosyncratic volatility.     

World market risk,country-specific risk and expected returns in international stock markets

This paper determines whether the world market risk, country-specific total risk, and country-specific idiosyncratic risk are priced in an international capital asset pricing model (ICAPM). Portfolio-level analyses, country-level cross-sectional regressions, stacked time-series, and pooled panel regressions indicate that the world market risk is not, but country-specific total and idiosyncratic risks are significantly priced in an ICAPM framework with partial integration. This result is robust to different methods for estimating risk measures, different investment horizons, and after controlling for the countries’ aggregate dividend yield, earnings-to-price ratios, inflation risk, exchange rate uncertainties, aggregate volatility risk, and past return characteristics. The main findings turn out to be insensitive to the choice of one-factor vs. multifactor models used to estimate systematic and idiosyncratic risk measures.     

C-CAPM Refinements and the Cross-Section of Returns

This paper studies if the consumption-based asset pricing model can explain the cross-section of expected returns. The CRRA model and several refinements (habit persistence and idiosyncratic shocks) all imply that the conditional expected return is linearly increasing in the asset’s conditional covariance with consumption growth. Results from quarterly data on the 25 Fama-French portfolios suggest that the model has serious problems: there are large and systematic pricing errors. In addition, the estimated time-varying effective risk aversion coefficients appear implausible and are unrelated with most candidates for habit persistence and idiosyncratic risk.     

The Effectiveness of Consumption Taxes and Transfers as Insurance Against Idiosyncratic Risk

We quantitatively evaluate the effectiveness of a consumption tax and lump-sum transfer program as insurance against idiosyncratic earnings risk. We use a heterogeneous agent, incomplete markets model in which households adjust savings and employment in each period in the presence of idiosyncratic productivity risk and a borrowing constraint. The model is calibrated to the U.S. economy. We find a weak insurance effect of the consumption tax and transfer program. Expanding the tax and transfer program from the current U.S. level increases the capital-output ratio and reduces the interest rate. Consumption inequality also decreases only slightly.     

Aggregate implications of micro asset market segmentation

An extensive empirical literature finds that micro asset markets are segmented from one another. We develop a consumption-based asset pricing model to quantify the aggregate implications of a financial system comprised of many such segmented micro asset markets. We specify exogenously the level of segmentation that determines how much idiosyncratic risk traders bear in their micro market and calibrate the segmentation to match facts about systematic and idiosyncratic return volatility. In our benchmark model traders bear 30% of their idiosyncratic risk, the unconditional aggregate equity premium is 2.4% annual, and the welfare costs of segmentation are substantial, 1.8% of lifetime consumption.     

Idiosyncratic Consumption Risk and the Cross Section of Asset Returns

This paper investigates the importance of idiosyncratic consumption risk for the cross‐sectional variation in asset returns. We find that besides the rate of aggregate consumption growth, the cross‐sectional variance of consumption growth is also a priced factor. This suggests that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns reflect their attempts to reduce their exposure to this risk. The resulting two‐factor consumption‐based asset pricing model significantly outperforms the CAPM, and its performance compares favorably with that of the Fama–French three‐factor model.     

The valuation of nonsystematic risks and the pricing of Swedish lottery bonds

Swedish government lottery bonds have coupon payments determinedby lottery. They offer a unique opportunity to study a securitywith uncertain payoffs having a known, observable distribution.The risk associated with the lotteries is idiosyncratic by constructionand should not command a risk premium in equilibrium. The bondsare traded in two forms, allowing us to evaluate the rewardsto bearing extra lottery risk. Despite its idiosyncratic nature,we find prices appear to reflect aversion to this risk. We evaluatethe empirical determinants of this differential pricing andpossible explanations for it.     

Human capital risk in life-cycle economies

The aggregate effects of market incompleteness are studied in a model where agents face idiosyncratic, uninsurable human capital investment risk. Using a life-cycle model with a version of a Ben-Porath (1967) human capital accumulation technology, stationary equilibria of calibrated cases are analyzed in which risk arises from specialization risk and career risk. With career risk only, stationary equilibria resemble those studied by Aiyagari (1994), and the impact of uninsurable idiosyncratic risk is relatively small. With a significant amount of specialization risk, however, stationary equilibria are severely distorted, with human capital about 57 percent as large as its complete markets counterpart.     

Loss aversion and the asymmetric transmission of monetary policy

There is widespread evidence that monetary policy exerts asymmetric effects on output over contractions and expansions in economic activity, while price responses display no sizeable asymmetry. To rationalize these facts we develop a dynamic general equilibrium model where households’ utility depends on consumption deviations from a reference level below which loss aversion is displayed. State-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption generate competing effects on output and inflation. Contractions face the Central Bank with higher responsiveness of output to interest rate changes, as well as a flatter aggregate supply schedule.     

Financial derivatives and bank risk: evidence from eighteen developed markets

We examine the relationship between equity risk and the use of financial derivatives with a sample of 555 banks from eighteen developed markets from 2006 to 2015. Our main findings suggest that banks’ use of financial derivatives increased their risk. This increase in risk can be driven by banks’ use of derivatives for speculative purposes, by suboptimal hedging to obtain hedge accounting status, or from accounting mismatches that generate volatility in earnings. We also show that this relationship is nonlinear. Too-Big-To-Fail banks and those that employ a traditional retail banking business model are subject to lower idiosyncratic risk. We address endogeneity concerns using instrumental variables capturing the use of derivatives with portfolio ranking. Overall, our study contributes to understanding the impact of derivatives use on bank risk and the risk consequences of a bank’s business model choice.