Large Negative Shocks Research Articles

Level shifts in stock returns driven by large shocks

Abstract This paper employs a parametric model of persistent (level) shifts in the conditional mean of stock market returns which are endogenously driven by large positive or negative return shocks. These shocks can be taken to reflect important market announcements, monetary policy regime changes and/or changes in business conditions affecting stock market. The model assumes that both the timing and size of breaks are stochastic. The last property of the model distinguishes it from other nonlinear models of the literature employed to capture level shifts in stock returns. Implementation of the model to the US stock market indicates that it can successfully capture level shifts in the mean of the aggregate return of this market which follow a cyclical pattern. Most of these shifts are triggered by negative large return shocks. The latter can be of smaller magnitude than that of the positive ones. Finally, the paper shows that the model can be employed to successfully forecast future expected stock returns.

Editors’ Introduction

Editors’ Introduction

Structural Breaks in Stock Returns Driven by Large Shocks

This paper employes a parametric model of structural breaks in the mean of stock returns which allows them to be endogenously driven by large positive or negative stock market return shocks. These shocks can be taken to reflect important market announcements, monetary policy regime shifts and/or changes in business conditions which affect stock market. The model assumes that both the timing and size of breaks are stochastic. The last property of the model distinguishes it from models suggested in the literature to capture structural breaks or regime shifts in the mean of stock returns. Implementation of the model to the US stock market indicates that the model can successfully capture structural breaks in the mean of the aggregate return of this market. Most of these breaks are triggered by negative large return shocks. The latter can be of smaller magnitude that the positive ones. Finally, the paper shows that the model can be employed to successfully forecast future expected stock returns.

The real consequences of financial stress

We introduce a dynamic banking-macro model, which abstains from conventional mean-reversion assumptions and in which—similar to Brunnermeier and Sannikov (2010)—adverse asset-price movements and their impact on risk premia and credit spreads can induce instabilities in the banking sector. To assess such phenomena empirically, we employ a multi-regime vector autoregression (MRVAR) approach rather than conventional linear vector autoregressions. We conduct bivariate empirical analyses, using country-specific financial-stress indices and industrial production, for the U.S., the UK and the four large euro-area countries. Our MRVAR-based impulse-response studies demonstrate that, compared to a linear specification, response profiles are dependent on the current state of the economy as well as the sign and size of shocks. Previous multi-regime-based studies, focusing solely on the regime-dependence of responses, conclude that, during a high-stress period, stress-increasing shocks have more dramatic consequences for economic activity than during low stress. Conducting size-dependent response analysis, we find that this holds only for small shocks and reverses when shocks become sufficiently large to induce immediate regime switches. Our findings also suggest that, in states of high financial stress, large negative shocks to financial-stress have sizeable positive effects on real activity and support the idea of “unconventional” monetary policy measures in cases of extreme financial stress.

A Multivariable System Approach for the Assessment of the Influence of Fiscal Policy to Business Cycle Shocks

The authors consider a multivariable system comprising a set of macroeconomic variables as inputs, states and outputs. In this setting the authors assess the control potential of fiscal policy versus a large negative business cycle shock that affects the output of the system. The inputs considered for this matter are the cyclical components of government spending and taxes. The states are the cyclical components of consumption and investment. These variables convey information to the policy maker at each time period. The output of the system is the cyclical component of GDP. In order to assess the control potential of government fiscal policy we begin by solving an optimal control problem minimizing the deviations of log GDP from its trend subject to a multivariable system and a set of input - output inequality constraints. Based on the results obtained the authors propose a set of optimal control indicators used to evaluate the effectiveness of fiscal policy action against a large negative business cycle shock and the potential controllability of the system.

Accounting Conservatism and Creditor Recovery Rate

We examine the relation between accounting conservatism and creditor recovery rates for firms in default. We also test the link between conservatism and the length of distress resolution proceedings. We find creditors of firms with more conservative accounting prior to default have significantly higher recovery rates and shorter duration of bankruptcy resolution. Moreover, conservative firms are more likely to violate debt covenants prior to default and more timely to enter bankruptcy proceedings after large negative shocks. Last, conservative firms show a significantly higher probability of emerging from bankruptcy. These results suggest accounting conservatism preserves creditor value conditional on default.

Health Shocks, Credit Scores, and Strategic Behavior with Credit Cards

The paper solves a puzzle related to unsecured credit and the use of credit scores. With credit scores increasingly present in credit decisions, and with the increased use of credit cards, especially in categories at risk of large negative health shocks, asymmetry of information between banks and individuals opens up wider possibilities for strategic behavior on the part of the latter. In this paper I analyze consumer strategic behavior in the credit market when faced with exogenous health shocks in the presence of banking institutions that rely on credit scores as a form of indicator of creditworthiness. By introducing multiple sources for asymmetry of information in the credit market, something not done in prior models, and introducing a dynamic discount factor, I find that the rational consumer engages in strategic behavior specific to their credit score. The paper solves an empirically parameterized model of life cycle consumption and borrowing focusing on unsecured credit and allowing for default in the presence of health shocks. It also allows for the simultaneous holding of both an interest bearing asset and unsecured debt. The findings support the hypothesis that exogenous credit shocks affect the behavior and the degree of strategy involved. While I do not possess actual consumer data on default, I develop some stylized empirical evidence in line with predictions of the theoretical model.

Housing and debt over the life cycle and over the business cycle

Housing and mortgage debt are studied in a quantitative general equilibrium model. The model matches wealth distribution, age profiles of homeownership and debt, and frequency of housing adjustment. Over the cycle, the model matches the cyclicality and volatility of housing investment, and the procyclicality of debt. Higher individual income risk and lower downpayments can explain the reduced volatility of housing investment, the reduced procyclicality of debt, and part of the reduced volatility of GDP. In an experiment that mimics the Great Recession, countercyclical financial conditions can account for large drops in housing activity and debt following large negative shocks.

Optimal investment, consumption–leisure, insurance and retirement choice

In this paper, we study an optimal consumption–leisure, investment, insurance and retirement choice problem of an infinitely lived economic agent with constant elasticity of substitution (CES) preferences. We incorporate random insurable losses that are independent of risky asset returns (negative monetary shocks) and impose short-sale constraint on the risky asset to formulate this optimal choice model. When the wealth process is subject to insurable negative monetary shocks produced by a general marked point process, the challenge is to derive an optimal allocation of the agent’s wealth between a portfolio investment and an insurance (costly) strategy. Without imposing the level of insurance to be within interval \(\left[ {0,1} \right]\); we capture the agent’s instantaneous preferences for consumption and leisure via CES preference, while integrating the optimal consumption–leisure–work tradeoffs, the optimal portfolio selection, optimal level of insurance and his/her optimal retirement time. We use the Martingale technique to formulate the optimization problem and solve the optimal policies of the agent by applying the variational inequality arising from the dual functions of the optimal stopping times. Our results demonstrate that a lack of insurance against large negative monetary shocks is positively correlated with lower participation rate in the equity market and high savings rates when short-sale constraint is binding. The optimal retirement time is characterized as the first time when his/her wealth exceeds a critical level of wealth.

Dissertation Summary: Innovation and Industry Development: Lessons from the British Cotton Textile Industry During the U.S. Civil War

This dissertation uses the large negative shock to the British cotton textile industry, caused by the U.S. Civil War, in order to test three long-running questions about innovation. Chapter one provides the first empirical test of the leading theory of directed technical change, introduced by Acemoglu (2002). I show that the shortage of U.S. cotton increased innovation in technologies related to Indian cotton, the main alternative, and increased the relative price of Indian cotton, confirming the key predictions of the theory. Chapter two introduces a new methodology for testing whether the existing stock of knowledge affects the level of new innovation and applies the methodology using the empirical setting. Chapter three considers the impact on the location of industries in Northern England. My results provide causal evidence that temporary shocks, acting through inter-industry Marshallian spillovers, can affect the long-run location of economic activity.

Time–Varying Dynamics and Asymmetric Effects of the Fama–French Factor Betas

We examine the impact of information shocks on systematic equity risk in a multiple-factor linear model framework. Using nonparametric and parametric models, we test for the presence of asymmetric effects of information shocks on the Fama–French factor betas. Overall, we document that market, size and book-to-market betas display different asymmetry patterns with respect to new information. More specifically, we find that market factor betas increase (decrease) following large negative (positive) market innovations. No evidence of an asymmetric response to the news is found for the size (SMB) factor betas. The book-to-market betas seem to decrease (increase) following large negative (positive) shocks to the book-to-market (HML) portfolio. Based on dynamic estimates of our empirical Fama–French betas we derive the economic values which an investor can gain by using dynamic factor loadings in portfolio selection. Finally, using stochastic dominance principles, we compare the performance of industry hedge portfolios.

Booms and Systemic Banking Crises

Banking crises are rare events that break out in the midst of credit intensive booms and bring about particularly deep and long-lasting recessions. This paper attempts to explain these phenomena within a textbook DSGE model that features a non-trivial banking sector. In the model, banks are heterogeneous with respect to their intermediation skills, which gives rise to an interbank market. Moral hazard and asymmetric information in this market may lead to sudden interbank market freezes, banking crises, credit crunches and, ultimately, severe recessions. The model can potentially generate various types of banking crises. But the typical crisis breaks out endogenously, during a credit boom generated by a sequence of small positive supply shocks; it does not result from a large negative exogenous shock. Simulations of a calibrated version of the model indicate that it can mimic the main dynamic patterns of banking crises.

Wage Theory, New Deal Labor Policy, and the Great Depression: Were Government and Unions to Blame?

A growing number of economists blame the length and severity of the Great Depression on factors that rigidified wage rates, raised production costs, and interfered with the market allocation of labor. The target of their critique is President Franklin Roosevelt's New Deal labor program, which they portray as creating a series of large negative supply shocks through encouragement of unions, minimum wages, unemployment insurance, and other anticompetitive industrial relations practices. The author uses a combination of institutiognal and Keynesian theory to present the other side of the story. Drawing principally from the works of J. R. Commons and J. M. Keynes, he develops both a spending and a productivity rationale for stable wages during the Great Depression and demonstrates that the New Deal's interventionist labor program was on balance necessary and beneficial. He also highlights the neglected macro-economic dimension of industrial relations theory and policy.

Shifts in Volatility Driven by Large Stock Market Shocks

This paper presents a new stochastic volatility model which allows for persistent shifts in volatility of stock market returns, referred to as structural breaks. These shifts are endogenously driven by large return shocks (innovations), reflecting large pieces of market news. These shocks are identified from the data as being bigger than the values of two threshold parameters of the model: one for the negative shocks and one for the positive shocks. The model can be employed to investigate economic (or market) sources of volatility shifts, without relying on exogenous information from the sample. In addition to this, it has a number of interesting features which enables us to study the dynamic or changing in magnitude effects of large return shocks on future levels of market volatility. The above properties of the model are shown based on a study for the US stock market volatility. For this market, the model identifies from the data as large negative return shocks these which are smaller than -2.05% on weekly basis, while as large positive return shocks those which are bigger than 2.33%.

Forward-Looking Tail Risk Exposures at U.S. Bank Holding Companies

This paper develops a simple method for quantifying banks’ exposures to large (negative) shocks in a forward-looking manner. The method is based on estimating banks’ share prices sensitivities to (market) put options and does not require the actual observation of tail risk events. We find that estimated (excess) tail risk exposures for U.S. Bank Holding Companies are negatively correlated with their share price beta, suggesting that banks which appear safer in normal periods are actually more crisis prone than their beta would suggest. We also study the determinants of banks’ tail risk exposures and find that their key drivers are uninsured deposits and non-traditional activities that leave assets on banks’ balance sheets.

Safe Haven Assets and Investor Behaviour Under Uncertainty

Financial crises and contagion have highlighted the need for safe haven assets. However, their existence, role and interactions are not well understood. We analyze the two most prominent yet fundamentally different safe haven assets, US government bonds and gold. Our econometric analysis explicitly models the dynamic interaction between these assets and the global stock market. While both assets appear to act as safe havens, we find that gold, in contrast to US government bonds, becomes increasingly sensitive to large negative shocks in the stock market. Gold therefore appears to be a stronger safe haven in extreme conditions despite the fact that it is more risky and less liquid than bonds. We offer a behavioral interpretation to explain our findings.

Borrowing Constraints and House Price Dynamics: The Case of Large Shocks

We study how household borrowing constraints shape house price dynamics. We consider the fully non-linear dynamics following large aggregate shocks in a calibrated OLG model with standard preferences. We find that the main effect of a down payment constraint is to make house price dynamics asymmetric between large positive and large negative income shocks: prices increase rapidly following the impact effect of a large adverse income shock but decline slowly following the impact effect of a positive income shock. This asymmetry stems from the fact that the share of borrowing constrained households changes over time. However, the down payment constraint does not substantially magnify the impact effect of adverse income or interest rate shocks.

Large Shocks in Menu Cost Models

How do prices react to large aggregate shocks? Our new micro-data evidence on value-added tax changes shows that prices react (i) flexibly and (ii) asymmetrically to large positive and negative shocks. We use it to quantitatively evaluate the performance of prominent pricing models. We show that standard time-dependent models are unable to reproduce either of these facts. A realistically calibrated state-dependent menu cost model, in contrast, is successful in matching the observed price responses. Its success lies in its ability to capture the exploding fraction of price changes for large shocks. The evidence facilitates comparison of different menu cost models and raises doubts on alternative pricing models with information or search frictions as sole reasons for price rigidity.

Economic Shocks, Diversification, and Forest Use in Uganda

We investigate household outcomes arising from economic shocks in rural Uganda, focusing on patterns of income diversification and forest use, and the role of assets in shaping ex post response to shocks. Income-poor households and those with below-average landholdings are observed to have more diversified income portfolios than their cohorts. Households encountering above-average losses tend to have more diversified income portfolios subsequent to the losses. Larger negative shocks are associated with greater use of the forest in subsequent periods, especially among asset-poor households. Findings suggest that development of better safety nets would reduce both vulnerability and forest pressure. <i>(JEL O12, Q23)</i>

Private Sector Risk and Financial Crises in Emerging Markets

Investment necessary for growth is risky and often requires external financing. We present a model in which capital market imperfections separate countries into a safe credit club of industrial countries, with low interest rates and steady credit access and a risky club of emerging markets, with high interest rates and volatile access. In an emerging market, a large negative productivity shock interacts with credit-market imperfections to trigger a severe contraction in external lending. Domestic agents react with widespread default. We calibrate to South Korean parameters and argue that the 1998 financial crisis could have been the downside of risky investment financed in imperfect capital markets.