Equilibrium Asset Pricing Research Articles

Volatility Ambiguity, Portfolio Decisions, and Equilibrium Asset Pricing

Volatility Ambiguity, Portfolio Decisions, and Equilibrium Asset Pricing

Asset prices when large investors interact strategically

This paper examines equilibrium asset prices and leverage in an exchange economy populated with both retail and institutional investors. Institutional investors influence the price of the stocks they trade and are aware of the price impact of the opponent and, thus, interact strategically. Because of the price impact, institutional investors decrease their demand for stocks and lend money to the retail sector, thereby increasing leverage in the economy. The risk-free rate (equity premium) tends to be lower (higher) as compared to an economy populated by retail investors only. Retail investors' compensation for liquidity provision depends on the behavior of institutional investors and the state of the economy.

Equilibrium asset pricing with short rate risk

Equilibrium asset pricing with short rate risk

Research on Asset Chain Pricing under Asymmetric Information

This paper investigates the asset pricing problem in the context of asymmetric information, focusing on the asset chain, and derives an expression for equilibrium asset prices. The findings of this study contribute to our understanding of how information asymmetry affects asset prices and can be used to inform investment decisions in markets with asymmetric information. Future research could explore the implications of these results for other types of assets or for different market conditions. Moreover, policymakers and regulators could also use these findings to design better disclosure requirements and improve market transparency, which could ultimately benefit investors and promote market efficiency. It is essential to continue investigating the impact of information asymmetry on asset prices to develop a more comprehensive understanding of financial markets. Using this equilibrium price expression, the author demonstrates that asset chain-based pricing can help mitigate the volatility of the equilibrium price. This finding could have significant implications for investors and policymakers seeking to stabilize asset prices in volatile markets. Further research could also investigate the practical applications of this pricing model in real-world investment scenarios. The study sheds light on the role of asymmetric information in asset pricing and highlights the potential benefits of asset chain-based pricing.

Overextrapolation of disaster probabilities and asset pricing in a production economy

In this paper, the overextrapolation belief about the jump intensity of disaster risk is incorporated into an equilibrium asset pricing model in a production economy. The theoretical results, which are dependent on the level of the jump intensity, show that overextrapolation may induce over/underinvestment and under/overconsumption. Moreover, it is predicted that the overextrapolative agent will always overreact on investment and consumption, which results in higher volatility in the economy and generates a higher equity risk premium under the equilibrium model. However, the effects of overextrapolation on the interest rate are ambiguous. Finally, we find that the overextrapolative agent suffers significant welfare loss due to the distortion of investment and consumption, especially when the jump intensity is far from the long-run mean.

Asset holders’ consumption risk and tests of conditional CCAPM

We test the conditional consumption-CAPM using asset holders’ consumption and find that the time variation in the prices of asset holders’ consumption risk is procyclical. This puzzling time variation is at odds with the implication of existing consumption-based equilibrium asset pricing models. We show that our finding is a salient feature of the data observed in multiple asset classes (aggregate equity market, equity portfolios, bond portfolios, and commodities portfolios), using different measures of consumption (household survey data and high-frequency retail shopping data) and alternative empirical methodologies.

Noise and Financial Stylized Facts: A Stick Balancing Approach.

In this work, we address the beneficial role of noise in two different contexts, the human brain and financial markets. In particular, the similitude between the ability of financial markets to maintain in equilibrium asset prices is compared with the ability of the human nervous system to balance a stick on a fingertip. Numerical simulations of the human stick balancing phenomenon show that after the introduction of a small quantity of noise and a proper calibration of the main control parameters, intermittent changes in the angular velocity of the stick are able to reproduce the most basilar stylized facts involving price returns in financial markets. These results could also shed light on the relevance of the idea of the "planetary nervous system", already introduced elsewhere, in the financial context.

Understanding the Ownership Structure of Corporate Bonds

Insurers are the largest institutional investors of corporate bonds. However, a standard theory of insurance markets, in which insurers maximize firm value subject to regulatory or risk constraints, predicts no allocation to corporate bonds. We resolve this puzzle in an equilibrium asset pricing model with leverage-constrained households and institutional investors. Insurers have relatively cheap access to leverage through their underwriting activity. They hold a leveraged portfolio of low-beta assets in equilibrium, relaxing other investors’ leverage constraints. The model explains recent empirical findings on insurers’ portfolio choice and its impact on asset prices. (JEL G11, G12, G22, G23)

An Equilibrium Model for the Cross Section of Liquidity Premia

We study a risk-sharing economy where an arbitrary number of heterogeneous agents trades an arbitrary number of risky assets subject to quadratic transaction costs. For linear state dynamics, the forward–backward stochastic differential equations characterizing equilibrium asset prices and trading strategies in this context reduce to a coupled system of matrix-valued Riccati equations. We prove the existence of a unique global solution and provide explicit asymptotic expansions that allow us to approximate the corresponding equilibrium for small transaction costs. These tractable approximation formulas make it feasible to calibrate the model to time series of prices and trading volume, and to study the cross section of liquidity premia earned by assets with higher and lower trading costs. This is illustrated by an empirical case study. Funding: J. Muhle-Karbe is partially supported by the CFM-Imperial Institute of Quantitative Finance. C. Yang is supported by the Hong Kong Research Grants Council [Grant 24207621] and a University Startup Grant from the Chinese University of Hong Kong.

Generalized disappointment aversion and the cross-section of stock returns

ABSTRACT Based on Epstein and Zin’s recursive utility function, this paper integrates generalized disappointment aversion preferences to derive an intertemporal equilibrium asset pricing model (ICAPM). We show that in addition to discount-rate news, cash-flow news, and news about future risk, four factors related to disappointment are priced. These four factors are a downstate factor, discount-rate downside news, cash-flow downside news, and downside news about future risk. We find that our seven-factor model can explain the cross-section of expected returns across portfolios sorted by size, book-to-market, investment, operating profitability, and momentum. Both the seven-beta ICAPM and the restricted seven-beta ICAPM suggest that disappointment-averse investors are more sensitive to cash-flow news and cash-flow downside news than other news terms and therefore demand higher premiums. Our results show that the seven-beta ICAPM has better performance for most portfolios and provides empirical support for investors’ asymmetric preferences.

Extreme Inflation and Time-Varying Expected Consumption Growth

In a parsimonious regime switching model, we find strong evidence that expected consumption growth varies over time. Adding inflation as a second variable, we uncover two states in which expected consumption growth is low, one with high and one with negative expected inflation. Embedded in a general equilibrium asset pricing model with learning, these dynamics replicate the observed time variation in stock return volatilities and stock-bond return correlations. They also provide an alternative derivation for a measure of time-varying disaster risk suggested by Watcher [ Wachter J (2013 ) Can time-varying risk of rare disasters explain aggregate stock market volatility? J. Finance 68(3):987–1035]. implying that both the disaster and the long-run risk paradigm can be extended toward explaining movements in the stock-bond correlation. This paper was accepted by Kay Giesecke, finance. Funding: We gratefully acknowledge research and financial support from the Leibniz Center for Financial Research SAFE (formerly Research Center SAFE, funded by the State of Hessen initiative for research LOEWE). Supplemental Material: The data files and online appendices are available at https://doi.org/10.1287/mnsc.2022.4451 .

Belief aggregation for representative agent models

AbstractRepresentative agent models pin down equilibrium asset prices of an underlying heterogeneous agents economy through the utility maximization problem of a representative agent evaluated at aggregate endowment levels. This paper considers a complete markets asset exchange economy in which all economic agents are expected utility maximizers who share the same risk preferences but may have heterogeneous endowments and beliefs. For arbitrary well‐behaved Bernoulli utility functions we derive belief aggregation formulas that characterize the beliefs of an expected utility maximizing representative agent.

Risk premia, asset price bubbles, and monetary policy

We develop a dynamic general equilibrium asset pricing model with heterogeneous beliefs to study the effects of monetary policy on prices, risk premia, asset price bubbles, and financial stability. We propose a new framework for monetary policy with respect to bubbles. Because bubble risk premia arise from an interaction between disagreements among investors and dynamic trading constraints, under a non-accommodative monetary policy, liquidity adjusted risk and bubble risk premia increase. What matters for policy is the trading constrained fraction/mass of agents that disagree about fundamentals (i.e. optimists/pessimists). Accommodative policy can lead to a larger fraction of trading constrained agents that disagree, larger bubbles, and increased systemic risk. An implication of our results is that accommodative monetary policy in response to the Covid-19 crisis does not increase systemic risk due to asset price bubbles, as long as the policy keeps inflation under control.

The saving, human wealth and asset pricing nexus: Evidence from around the world

The present study examines the dynamics of the saving, human wealth and asset pricing nexus across developed and emerging economies. We introduce two equilibrium asset pricing models in an intertemporal capital asset pricing framework, including the priced factors human wealth and market portfolio in the first framework and the saving and market portfolio in the second framework. Both asset pricing frameworks consist of two-factor, four-factor and five-factor asset pricing models. We control for size and value factors in the four-factor model and size, value and momentum factors in the five-factor model. The IV-GMM estimation and GRS test results indicate that human wealth and market portfolio for the first framework and saving and market portfolio in the second framework are primary priced factors in explaining the average returns for developed economies and the aggregate level. On the contrary, both frameworks fail to yield significant results explaining the average returns for emerging economies.

Regret-sensitive equity premium

In a static Lucas tree economy, we propose a model that the representative agent is sensitive to regret, that is, the agent is affected by not only the actual outcome but also value-differences between actual and foregone consequences. Our model generalizes the classical simple regret model pioneered by Bell (1982) and Loomes and Sugden (1982), and makes it possible to derive the equilibrium asset price and to see when the regret effect decreases the price. To verify that our model predicts sufficient decreases of the equilibrium price to explain the empirically high risk premium, we analyze the data of U.S. stock market and GDP growth rates during 1871–2018. The numerical calculation indicates that the estimated equilibrium price is small enough to explain the equity premium puzzle.

Treasury inconvenience yields during the COVID-19 crisis

In sharp contrast to most previous crisis episodes, the Treasury market experienced severe stress and illiquidity during the COVID-19 crisis, raising concerns that the safe-haven status of US Treasuries may be eroding. We document large shifts in Treasury ownership and temporary accumulation of Treasury and reverse repo positions on dealer balance sheets during this period. We build a dynamic equilibrium asset pricing model in which dealers subject to regulatory balance sheet constraints intermediate demand/supply shocks from habitat agents and provide repo financing to levered investors. The model predicts that Treasury inconvenience yields, measured as the spread between Treasuries and overnight-index swap rates (OIS), as well as spreads between dealers’ reverse repo and repo rates, should be highly positive during the COVID-19 crisis, as is confirmed in the data. The same model framework, adapted to the institutional setting in 2007–2009, can also explain the negative Treasury-OIS spread observed during the Great Recession.

Equilibrium asset pricing and the cross section of expected returns

In a mean-variance framework with a representative agent, any linear model for the cross section of expected returns can be supported as an equilibrium as long as the market portfolio is spanned by the factor mimicking portfolios. Any set of factors is admissible as long as the spanning condition is satisfied. Factors based on size, book-to-market, momentum, investment, profitability, behavioral biases, principal components, or any combination of these can be used as equilibrium factors. An equilibrium model with M risk factors can be reduced to a collection of M models where each model has a single risk factor, which is covariance with the market portfolio.

Equilibrium asset pricing with transaction costs

We study risk-sharing economies where heterogeneous agents trade subject to quadratic transaction costs. The corresponding equilibrium asset prices and trading strategies are characterised by a system of nonlinear, fully coupled forward–backward stochastic differential equations. We show that a unique solution exists provided that the agents’ preferences are sufficiently similar. In a benchmark specification with linear state dynamics, the empirically observed illiquidity discounts and liquidity premia correspond to a positive relationship between transaction costs and volatility.

Stability of equilibrium asset pricing models: A necessary and sufficient condition

We obtain an exact necessary and sufficient condition for the existence and uniqueness of equilibrium asset prices in infinite horizon, discrete-time, arbitrage free environments. Using local spectral radius methods, we connect the condition, and hence the problem of existence and uniqueness of asset prices, with the recent literature on stochastic discount factor decompositions. Our results include a globally convergent method for computing prices whenever they exist. Convergence of this iterative method itself implies both existence and uniqueness of equilibrium asset prices.

An Equilibrium Model for the Cross-Section of Liquidity Premia

We study a risk-sharing economy where an arbitrary number of heterogenous agents trades an arbitrary number of risky assets subject to quadratic transaction costs. For linear state dynamics, the forward-backward stochastic differential equations characterizing equilibrium asset prices and trading strategies in this context reduce to a system of matrix-valued Riccati equations. We prove the existence of a unique global solution and provide explicit asymptotic expansions that allow us to approximate the corresponding equilibrium for small transaction costs. These tractable approximation formulas make it feasible to calibrate the model to time series of prices and trading volume, and to study the cross-section of liquidity premia earned by assets with higher and lower trading costs. This is illustrated by an empirical case study.