Behavior Of Asset Prices Research Articles

Asset Pricing in a Production Economy with Heterogeneous Investors

This paper is a theoretical examination of the stochastic behavior of equilibrium asset prices in an economy consisting of a production process controlled by a state variable representing the state of technology. The investors with different degrees of risk aversion and time preferences trade and lend among themselves in order to maximize their individual utilities of life time consumption. The allocation of wealth fluctuates randomly among them and acts as a state variable against which each investor wants to hedge. This hedging motive complicates the investor's portfolio choice and the equilibrium in the production economy. A general method of constructing equilibrium asset prices is developed and the wealth effect in the general equilibrium is discussed. The equilibrium market prices of risks and risk-free rate in a production economy with one representative investor has been presented by Cox, Ingersoll and Ross (1985). Considerable progress has been made by Dumas (1989) and Vasicek (2005) on the case of heterogeneous investors, however a complete description of the general equilibrium in the production economy with heterogeneous investors is yet to be developed. That is the focus of this paper. This paper establishes an economic model for the equilibrium asset prices by solving the joint optimization problem with proper market clearing conditions. The equilibrium conditions of the two party dynamic game are written as a set of two highly entangled nonlinear partial differential equations. The result can be extended to handle the case of multiple heterogeneous investors.

Consumption-Based Asset Pricing

This chapter reviews the behavior of financial asset prices in relation to consumption. The chapter lists some important stylized facts that characterize U.S. data, and relates them to recent developments in equilibrium asset pricing theory. Data from other countries are examined to see which features of the U.S. experience apply more generally. The chapter argues that to make sense of asset market behavior one needs a model in which the market price of risk is high, time-varying, and correlated with the state of the economy. Models that have this feature, including models with habit-formation in utility, heterogeneous investors, and irrational expectations, are discussed. The main focus is on stock returns and short-term real interest rates, but bond returns are also considered.

Co‐integration of housing prices and property stock prices: evidence from the Swedish market

The long run linkages between Swedish housing prices and property stock prices are investigated with the consideration that rental control system applied in Sweden could deviate asset prices from the suggested co‐integration. To confirm the degree of equilibrium, Error Correction Model with exogenous variables and the effect of the tax reform in 1991 are examined. Roles of rentals on the behavior of asset prices are also presented. This study confirms the existence of long‐term equilibrium between asset prices and indicates a semi‐strong efficiency of asset market. Furthermore, this study also suggests the effects of rentals on improving speed to the long‐term equilibrium.

Time variation in the tail behavior of Bund future returns

AbstractThe literature on the tail behavior of asset prices focuses mainly on the foreign exchange and stock markets, with only a few articles dealing with bonds or bond futures. The present article addresses this omission. It focuses on three questions using extreme value analysis: (a) Does the distribution of Bund future returns have heavy tails? (b) Do the tails change over time? (c) Does the tail index provide information that is not captured by a standard VaR approach? The results are as follows: (a) The distribution of high‐frequency returns of the Bund future is indeed characterized by heavy tails. The tails are thinner for lower frequencies, but remain significantly heavy even for daily data. (b) There are statistically significant breaks in the tails of the return distribution. (c) The likelihood of extreme price movements suggested by extreme value theory differs from that obtained by standard risk measures. This suggests that the tail index does indeed provide information not contained in volatility measures. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:387–398, 2004

Overconfidence and Speculative Bubbles

Motivated by the behavior of asset prices, trading volume, and price volatility during episodes of asset price bubbles, we present a continuous‐time equilibrium model in which overconfidence generates disagreements among agents regarding asset fundamentals. With short‐sale constraints, an asset buyer acquires an option to sell the asset to other agents when those agents have more optimistic beliefs. As in a paper by Harrison and Kreps, agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, bubbles are accompanied by large trading volume and high price volatility. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility.

Inspecting the Mechanism: closed‐form Solutions for Asset Prices in Real Business Cycle Models

We derive closed-form solutions for asset prices in an RBC economy. The equations are based on a log-linear solution of the RBC model and allow a clearer understanding of the determination of risk premia in models with production. We demonstrate not only why the premium of equity over the risk-free rate is small but also why the premium of equity over a real long-term bond is small and often negative. In particular, risk premia for equity and long real bonds are negative when technology shocks are permanent. Recently, a growing literature has explored the asset pricing implications of real business cycle (RBC) models. Examples are Rouwenhorst (1995), Jermann (1998) and Boldrin et al. (1995). 1 From a methodological point of view, models with production allow a more realistic modelling of consumption and dividends than do the pure exchange economies of Lucas (1978). However, explaining the behaviour of asset prices in production economies is also more challenging. For example, in an exchange economy, an increase in risk premia can be obtained by increasing risk aversion. This is not necessarily true in production economies, since agents can choose a smoother consumption path by substituting between work and leisure in response to productivity shocks. The papers just cited find that RBC models tend to generate counterfactual asset pricing implications unless some extreme form of rigidities is introduced. This paper attempts to provide a clearer understanding of the challenges posed by asset pricing behaviour for RBC models. Instead of solving a standard model numerically and simulating it over a large number of parameter permutations, we argue here that this understanding can be better developed by analysing approximate closed-form solutions for prices of a variety of financial assets. Although there are now many accurate solution algorithms available for solving RBC models (e.g., see the overview in Taylor and Uhlig (1990)), the approximate closed-form expressions obtained here make the relationship between asset prices and exogenous technology shocks particularly transparent by providing simple analytical expressions that decompose the effect of technology shocks on asset prices into (i) a direct effect due to the shock itself and (ii) an indirect effect stemming from capital accumulation.

Assessing the Impact of Changes in Transparency and Accountability at the Bank of Canada

The introduction of inflation targets in Canada in 1991 clarified the objectives of monetary policy. One of the objectives of the new policy was to ensure that the public would henceforth be able to more easily assess monetary policy performance based on the Bank of Canada's record at achieving low and stable inflation. An obvious question then is to ascertain whether in fact, as a former Governor stated, ...public commentary on monetary policy since 1991 has involved a fairer assessment of the performance of the Bank of Canada. Tests, using daily interest rate and exchange rates and monthly inflation and inflation forecast data, are presented which shed light on this question. Some comparative UK and US data are also used to address the issue whether central bank transparency and accountability have separate impact on the behavior of financial asset prices.

Is Arch Useful in High Frequency Foreign Exchange Applications?

One of the many challenges posed by the study of high frequency financial market data is to develop models capable of explaining asset price behaviour at a range of frequencies. At the same time as presenting researchers with new opportunities, it also calls into question whether standard time series models are useful in high frequency applications. This paper addresses this issue from two perspectives. First, a Monte Carlo procedure is used to investigate whether the unconditional distribution of high frequency foreign exchange returns can be approximated by the unconditional distribution of returns simulated by a range of popular stochastic processes. Second, high frequency data is used to generate and appraise forecasts of daily variance. Forecasts are evaluated using statistical criteria as well as a profitability measure based on a trading game in a pseudo options market. The simulation exercise demonstrates that the autoregressive conditional heteroskedasticity (ARCH) family of models is unable to reproduce the unconditional distribution of foreign exchange returns at frequencies higher than 24 hours. This is largely a legacy of the heavy-tailed feature of intraday returns. However, results from the forecasting analysis extend those in Andersen and Bollerslev (1998) by showing that a range of standard volatility models can in fact produce accurate forecasts of realized daily variance. In other words, it is possible for ARCH models to predict variability in the conditional second moment of daily foreign exchange returns. This is attributed to the use of frequently sampled data in the construction of estimates of realized variance (against which forecasts are measured). In addition, the inclusion of the sum of squared intraday returns in the Generalized ARCH(1,1) model yields improvements in the modelling, and most notably forecasting, of realized daily variance. This appears to be an artifact of the noise inherent in using the daily squared return as an estimator of realized daily variance. This paper demonstrates that whilst standard econometric models do not capture the intraday foreign exchange return generating process, this should not immediately preclude these models from high frequency applications. Instead, the forecasting exercise demonstrates practical benefits are easily attainable from using high frequency data to develop and evaluate existing asset pricing models.

Heterogeneous agent model with memory and asset price behaviour

The efficient markets hypothesis provides a theoretical basis on which technical trading rules (TTRs) are rejected as a viable trading strategy. TTRs, providing a signal to the user when to buy or sell asset based on such price patterns, should not be useful for generating excess returns. Technical traders tend to put little faith in strict efficient markets hypothesis. This approach relies on heterogeneity in the agent information and subsequent decisions either as fundamentalists or as technical traders. Switching between the technical trader's and fundamentalist's strategy is a basis of the cycle behaviour. This event is analysed by the Brock and Hommes (BH) model. Moreover, the memory case is added to this model because BH model was the memory-less model. This branch consists of a behaviour analysis among fundamentalists and technical traders. Here is a basis for endogenous source of the real business cycle.

Volatility via social flaring

A new explanation of kurtosis in asset price behavior is proposed involving flare attractors. Such attractors depend on chaotic fundamentals driving subsystems which trigger nonlinearly response functions each with a switching mechanism representing the changing of agents from stabilizing to destabilizing behavior. Heterogeneous agent types are shown by a set of these response functions that are interlinked. With a larger number of agent types system behavior resembles that of many financial markets. Such a model is consistent with newer approaches relying upon evolutionary learning mechanisms with heterogeneous agents as well as models depending on fractal characteristics.

A Dual Liquidity Model for Emerging Markets

The last few years have seen a significant re-evaluation of the models used to analyze crises in emerging markets. Recent models typically stress financial constraints or distorted financial incentives. While this certainly represents progress, these models share a weakness with the earlier work: neither is uniquely about emerging markets. Adaptations of the Mundell-Fleming model represent Argentina as a Belgium with larger external shocks. Likewise, emerging market models of financial constraints are adaptations of developed economy ones with tighter financial constraints. In our work, we have advocated a model which distinguishes between the financial constraints affecting borrowing and lending among agents within an emerging economy, and those affecting borrowing from foreign lenders. This 'dual liquidity' model offers a parsimonious description of the behavior of firms, governments, and asset prices during financial crises. It also provides prescriptions for optimal policy responses to these crises.

A Dual Liquidity Model for Emerging Markets

The last few years have seen a significant re-evaluation of the models used to analyze crises in emerging markets. Recent models typically stress financial constraints or distorted financial incentives. While this certainly represents progress, these models share a weakness with the earlier work: neither is uniquely about emerging markets. Adaptations of the Mundell-Fleming model represent Argentina as a Belgium with larger external shocks. Likewise, emerging market models of financial constraints are adaptations of developed economy ones with tighter financial constraints. In our work, we have advocated a model which distinguishes between the financial constraints affecting borrowing and lending among agents within an emerging economy, and those affecting borrowing from foreign lenders. This 'dual liquidity' model offers a parsimonious description of the behavior of firms, governments, and asset prices during financial crises. It also provides prescriptions for optimal policy responses to these crises.

Should Monetary Policy Respond to Asset Price Bubbles? Some Experimental Results

Should central banks respond to asset price bubbles? This paper explores this monetary policy question in a hypothetical economy subject to asset price bubbles. Despite the highly stylized structure of the model, the results reveal several practical monetary policy lessons. First, a monetary authority should generally respond to asset prices as long as asset prices contain reliable information about inflation and output. Second, this finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. Third, a monetary authority's desire to respond to asset prices falls dramatically as its preference to smooth interest rates rises. Finally, a monetary authority should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices.

Stochastic Volatility and Jumps Driven by Continuous Time Markov Chains

This paper considers a model where there is a single state variable that drives the state of the world and therefore the asset price behavior. This variable evolves according to a multi-state continuous time Markov chain, as the continuous time counterpart of (Hamilton 1989) model. It derives the moment generating function of the asset log-price difference under very general assumptions about its stochastic process, incorporating volatility and jumps that can follow virtually any distribution, both of them being driven by the same state variable. For an illustration, the extreme value distribution is used as the jump distribution. The paper shows how GMM and conditional ML estimators can be constructed, generalizing Hamilton's filter for the continuous time case. The risk neutral process is constructed and contingent claim prices under this specification are derived, in the lines of (Bakshi and Madan 2000). Finally, an empirical example is set up, to illustrate the potential benefits of the model.

International Debt and the Price of Domestic Assets

This paper examines the behavior of indebtedness, consumption, and asset prices in a small open economy in which the foreign real interest rate depends not only on an exogenous world interest rate and on indebtedness, but also on the value of the capital stock, viewed as an implicit collateral, and hence on the price of capital. The paper finds that the collateral effect magnifies the intensity of shocks to the economy and the duration of their impact. The collateral effect also generates additional distortions that could lead to overborrowing. The paper discusses the policy responses to these distortions.

International Debt and the Price of Domestic Assets

This paper examines the behavior of indebtedness, consumption, and asset prices in a small open economy in which the foreign real interest rate depends not only on an exogenous world interest rate and on indebtedness, but also on the value of the capital stock, viewed as an implicit “collateral,” and hence on the price of capital. The paper finds that the collateral effect magnifies the intensity of shocks to the economy and the duration of their impact. The collateral effect also generates additional distortions that could lead to overborrowing. The paper discusses the policy responses to these distortions.

Overreactions, Momentum, Liquidity, and Price Bubbles in Laboratory and Field Asset Markets

Laboratory asset markets provide an experimental setting in which to observe investor behavior. Over more than a decade, numerous studies have found that participants in laboratory experiments frequently drive asset prices far above fundamental value, after which the prices crash. This bubble-and-crash behavior is robust to variations in a number of variables, including liquidity (the amount of cash available relative to the value of the assets being traded), short-selling, certainty or uncertainty of dividend payments, brokerage fees, capital gains taxes, buying on margin, and others. This paper attempts to model the behavior of asset prices in experimental settings by proposing a "momentum model" of asset price changes. The model assumes that investors follow a combination of two factors when setting prices: fundamental value, and the recent price trend. The predictions of the model, while still far from perfect, are superior to those of a rational expectations model, in which traders consider only fundamental value. In particular, the momentum model predicts that higher levels of liquidity lead to larger price bubbles, a result that is confirmed in the experiments. The similarity between laboratory results and data from field (real-world) markets suggests that the momentum model may be applicable there as well.

Information and asset prices in complete markets exchange economies

This note analyzes the effect of public information, called news, on asset price behavior in Markovian (recursive) exchange economies with dynamically complete markets and risk-averse agents. A strong relationship between asset prices in two economies with the same fundamental structure but a different information structure is derived: asset prices in the economy with more information are a weighted average of asset prices in the corresponding economy with less information. This representation theorem implies that the unconditional mean of asset prices is independent of the information structure (news process) and that an increase in agents’ information (a decrease in agents’ forecast error of future dividends and/or discount factors) increases the volatility of asset prices (the unconditional variance of asset prices).

Market liquidity and its effect on option valuation and hedging

The model presented in this paper attempts to quantify the concept of liquidity and establishes a relation between various measures of market performance. Informational inefficiency is argued to be the main reason for the unavailability of an asset at its equilibrium price. The asset, however, can always be purchased at a higher price or sold at a lower price, depending on the market expectations, unless trading has ceased. The mathematical model describing the asset–price behaviour together with arbitrage considerations enable us to estimate the component of the bid–ask spread resulting from imperfect information. The impact of the market liquidity on hedging an option with another option as well as the underlying asset itself is also examined. In this last case uncertainty cannot be completely eliminated from the hedged portfolio, although a unique risk–minimizing strategy is found.

Leverage and House-Price Dynamics in U.S. Cities

We use city-level data to analyze the relationship between homeowner borrowing patterns and house-price dynamics. Our principal finding is that in cities where a greater fraction of homeowners are highly leveraged--i.e., have high loan-to-value ratios--house prices react more sensitively to city-specific shocks, such as changes in per-capita income. This finding is consistent with recent theories which emphasize the role of borrowing in shaping the behavior of asset prices.