Low Risk-free Rate Research Articles

Disaster learning and aggregate investment

We extend a production-based asset pricing model by introducing learning about disaster risk. The information is not perfect, and Bayesian learning is adopted to update beliefs about the likelihood of rare disasters. We show that disaster learning reconciles key stylized facts about macroeconomic quantities and financial markets. For macroeconomic quantities, during the crisis, the decline in aggregate investments is much worse than that of output, whereas the decline in aggregate consumption is moderate relative to that of output. Additionally, the model endogenously features lower consumption volatility and higher investment volatility than that of output. For financial markets, belief updating over a rare disaster produces a higher equity premium, lower risk-free rate, and more volatile stock returns. Finally, we show that jump intensity uncertainty accounts for a substantial fraction of the total welfare cost of rare disasters.

Government debt and risk premia

Risk premia increase with government debt. Debt-to-GDP ratios positively predict stock returns at short and long horizons in the U.S. and other advanced economies. Higher debt is also associated with higher bond premia and lower risk-free rates. Major government debt theories (liquidity, safety, crowding out) either do not address or are inconsistent with these findings. New evidence suggests that the increased risk premia provide compensation for larger fiscal risk; during periods of elevated debt, fiscal policy becomes more uncertain and less effective and can lead to debt crises. I quantify these mechanisms in an equilibrium model.

Asset Pricing Based on Micro Consumption

This paper proposes an estimable asset pricing model that builds upon micro consumption and reference-dependent preference. Central to the model is an S-shaped consumption utility function that is convex below the reference point. The model quantitatively accounts for both low risk-free rates and high equity premiums. The S-shaped consumption utility works by rationalizing the micro-level finding that, for many people, consumption growth correlates negatively with asset returns. When global concavity is maintained, the equity premium puzzle remains because the estimated degree of relative risk aversion given a high consumption-reference ratio is absurdly large.

Solving the Equity Premium Puzzle by unifying Economics and Finance

The Equity risk-premium and volatility puzzle - is it possible to have a high equity premium and a low risk-free rate with a plausible risk aversion- have received a great deal of attention but beyond this question, the fundamental issues of that puzzle are the followings: what are the economic representations that can provide such results? What are the relevant links between finance and economics? And what should be the consequences for economic decisions makers? The classic ways to model the financial economy with a representative agent placed in a Lucas tree model, i.e. maximizing consumption-based utility, where fruit is equivalent to dividend and consumption, failed to explain a high equity premium and a low risk free rate. Even more, simple changes in reasoning failed to provide a consistent macroeconomic and finance representation that sticks to reality. This paper presents a new eco-financial approach based on three major changes: the definition of Wealth and wealth increment and their utility for any agent instead of consumption, a permanent change of equilibrium theory, a more realistic model in which the agents fear much more crises than ordinary fluctuations. This model borrows two key principles from the model developed in Modigliani and Miller’s seminal papers: firstly an economy with investment opportunities in the market of goods and services and secondly an economy where rational agents always prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of dividend or growth in value .Main changes come from, we generalized this wealth approach to any agent, in a changing of equilibrium world, where crises are much more dreaded than ordinary negative events. We will show that it is a way to solve the equity premium and to make consistent: macro, micro, finance and reality.

A consumption-based asset pricing model with disappointment aversion and uncertainty shocks

We study a consumption-based asset pricing model with ‘good’ and ‘bad’ uncertainties. Good and bad uncertainties are characterized by two gamma distributions with time-varying shape parameters and they respectively represent potentially fat-tailed, skewed positive and negative innovations to consumption growth. The representative agent has generalized disappointment aversion preferences. We show that disappointment aversion is important for generating a low risk-free rate and high equity premium, and additionally, while the influence of the elasticity of intertemporal substitution (EIS) on equity premium is negligible, the EIS is important for delivering reasonable implications on the market prices of the two uncertainty components.

The determinants of negative net leverage policy: New evidence from Japan

A negative net leverage firm can immediately become a zero-leverage firm by repaying their outstanding debt; however, the majority of negative net leverage firms in Japan still have positive gross debt. This paper investigates the determinants of a negative net leverage policy. Previous literature argues that zero-leverage is the result of high growth opportunity. However, by using a sample of Japanese non-financial firms over the period 1991–2015, we find that the driving forces of negative net leverage policy are low growth opportunity, low default possibility, and high cash holdings. Furthermore, a lower risk-free rate induces firms to increase cash holding, and therefore decrease net leverage. As time goes by, negative net leverage firms cease to accumulate cash and gradually repay debt. We suggest that policymakers improve the investment environment and enhance the effective allocation of firm funding, especially during a period of low risk-free rates.

Asset Pricing in Production Economies with Learning About Rare Disasters

In rare disaster models, it is a major challenge to generate large equity premium and low risk-free rate by imposing realistic consumption jump size. This paper addresses this issue based on a dynamic general equilibrium production economy with learning about rare disasters. Essentially, the information about fundamentals driving rare downward jumps in the output process is not perfect and Bayesian learning is adopted to update beliefs about the likelihood of rare disasters. In the model, the belief dynamics are essential to reconcile the tension between financial markets and consumption data. Additionally, learning about high versus low disaster intensity can generate empirically plausible trend for the investment-output ratio. The economy also features that the impact of parameter uncertainty accounts for a substantial fraction of the total welfare effects of rare disasters.

Ambiguity, Low Risk-Free Rates and Consumption Inequality

Abstract Macroeconomists failed to predict the Great Recession, suggesting that the existing macroeconomic models may have been misspecified. Bearing in mind this potential misspecification or ‘model uncertainty’, how do agents’ optimal decisions change? Furthermore, how large are the welfare costs of model misspecification? To shed light on these questions, we develop a tractable continuous-time general equilibrium model to show that a fear of model misspecification reduces both the equilibrium interest rate and the relative inequality of consumption to income, making the model’s predictions closer to the data. Our quantitative analysis shows that the welfare costs of model uncertainty are sizable.

Risks to Human Capital

What is the connection between financing constraints and the equity premium? To answer this question, we build a model with inalienable human capital, in which investors finance individuals who can potentially become skilled. Though investment in skill is always optimal, it does not take place in some states of the world, due to moral hazard. In other states of the world, individuals acquire skill; however outside investors and individuals inefficiently share risk. We show that this simple moral hazard problem and the resultant financing friction leads to a realistic equity premium, a low riskfree rate, and severe negative consequences for distribution of wealth and for welfare. When investment fails to take place, the economy enters an endogenous disaster state. We show that the possibility of these disaster states distorts risk prices, even under calibrations in which they never occur in equilibrium.

Revisiting Asset Pricing with Uncertainty in Future Preferences

We demonstrate that uncertainty about future preferences is of first-order importance for understanding the history of aggregate asset prices. Our analysis shows that simply relaxing the assumption of deterministic aggregate elasticity of intertemporal substitution and relative risk aversion can resolve a large array of aggregate asset pricing puzzles. These puzzles include the high equity premium, low risk-free rate, and the predictability (and nonpredictability) relationships among price-dividend ratios, excess returns, and consumption or dividend growth. Our model also generates time variation of dividend yields, risk premia, excess return volatilities, and Sharpe ratios, as well as an upward-sloping real yield curve.

Climate Generated Disasters and Cataclysm in an Economy

I model the effects of climate change on a real business cycle model economy subjected to climate moderated disasters and the possibility of a worldwide cataclysm that destroys the economy. I find that the rise of greenhouse gas production in the economy leads to more frequent and more destructive disasters that affect the real economy, at the same time leading to lower risk-free rates and higher risk premiums.

Asset Return Dynamics under Habits and Bad Environment–Good Environment Fundamentals

We introduce a “bad environment–good environment” (BEGE) technology for consumption growth in a consumption-based asset pricing model with external habit formation. The model generates realistic non-Gaussian features of consumption growth and fits standard salient features of asset prices including the means and volatilities of equity returns and a low risk-free rate. BEGE dynamics additionally allow the model to generate realistic properties of equity index options prices and their comovements with the macroeconomic outlook. In particular, when option-implied volatility is high—as measured, for instance, by the VIX index—the distribution of consumption growth is more negatively skewed.

Asset Pricing with Housing Booms and Disasters

By extending Cumulant Generating Function-based pricing formulas to a two-good economy (non-housing and housing), we obtain closed-form solutions for asset prices. The presence of housing impacts risk aversion and induces time variation that is priced in the model. Since housing also brings about composition risk, we show that it introduces endogenously a long-run risk component into the consumption bundle dynamics. Estimating the model over the period 1959 -– 2020, we show that rare booms and busts events in housing expenditures is determinant in obtaining moderate housing risk premium and housing excess return volatility, both in line with empirical results. The real interest rate and both the level and volatility of the equity risk premium also fit the data owing to the presence of the COVID period into our sample period.

Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy?

A common criticism of behavioral economics is that it has not shown that the psychological biases of individual investors lead to aggregate long-run effects on both asset prices and macroeconomic quantities. Our objective is to address this criticism by providing a simple example of a production economy where individual portfolio biases cancel when summed across investors, but still have an effect on aggregate quantities that does not vanish in the long-run. Specifically, we solve in closed form a model of a stochastic general-equilibrium production economy with a large number of heterogeneous firms and investors. Investors in our model are averse to ambiguity and so hold portfolios biased toward familiar assets. We specify this bias to be unsystematic so it cancels out when aggregated across investors. However, because of holding under-diversified portfolios, investors bear more risk than necessary, which distorts the consumption of all investors in the same direction. Hence, distortions in consumption do not cancel out in the aggregate and therefore increase the price of risk and distort aggregate investment and growth. The increased risk from holding biased portfolios, which increases the demand for the risk-free asset, leading to a higher equity risk premium and a lower risk-free rate that match the values observed empirically. Furthermore, all investors survive in the long-run, and so the effects of their biases never vanish. Our analysis illustrates that idiosyncratic behavioral biases can have long-run distortionary effects on both financial markets and the macro-economy.

What Drives the Consumer Credit Spread? An Explanation Based on Rare Event Risk and Belief Dispersion

What drives consumers borrowing/lending and the credit spread over their debt? This paper offers a novel explanation based on rare event risk and belief dispersion in a dynamic general equilibrium model. Heterogeneous beliefs drive consumers to borrow, but the market is incomplete and subject to rare event risk and thus default endogenously occurs in equilibrium. The paper derives the credit spread in closed form and yields a credit spread similar to real data when the model is calibrated. The model also well captures the relationship between belief dispersion, risk-free rate and credit spread. It shows that belief dispersion, rare event risk and wealth distribution together drive both credit spread and risk-free rate. An increase in either rare event risk or belief dispersion leads to a higher credit spread and a lower risk-free rate. However, the underlying mechanisms are quite different, as the former (rare event risk) is due to substitution effect while the latter (belief dispersion) is due to wealth effect. The paper also makes a contribution to the literature on rare disaster by endogenizing default and clarifies Barro(2006)'s argument on the countervailing effects of rare disasters on interest rates.

Disaster recovery and the term structure of dividend strips

Recent empirical findings document downward-sloping term structures of equity return volatility and risk premia. An equilibrium model with rare disasters followed by recoveries helps reconcile theory with empirical observations. Indeed, recoveries outweigh the upward-sloping effect of time-varying disaster intensity and expected growth, generating downward-sloping term structures of dividend growth risk, equity return volatility, and equity risk premia. In addition, the term structure of interest rates is upward-sloping when accounting for recoveries and downward-sloping otherwise. The model quantitatively reconciles high risk premia and a low risk-free rate with the shape of the term structures, which are at odds in other models.

The Time-Varying Risk of Macroeconomic Disasters

While time-varying disasters can explain many characteristics of financial markets, their quantitative assessment is still missing. We propose a latent variable approach to estimate the time-varying probability of a macroeconomic disaster, using a dataset of 42 countries over more than 100 years. We find that disaster risk is volatile and persistent, strongly correlates with the dividend yield, and forecasts stock returns. A state-of-the-art model calibrated with our disaster risk estimates generates a large and volatile equity premium and a low risk free rate under standard assumptions. This evidence supports the idea that investors' fear of disasters drives equity premium dynamics.

Asset Return Dynamics Under Habits and Bad-Environment Good-Environment Fundamentals

We introduce a “bad environment–good environment” (BEGE) technology for consumption growth in a consumption-based asset pricing model with external habit formation. The model generates realistic non-Gaussian features of consumption growth and fits standard salient features of asset prices including the means and volatilities of equity returns and a low risk-free rate. BEGE dynamics additionally allow the model to generate realistic properties of equity index options prices and their comovements with the macroeconomic outlook. In particular, when option-implied volatility is high—as measured, for instance, by the VIX index—the distribution of consumption growth is more negatively skewed.

The Dynamics of Crises and the Equity Premium

It is a major challenge for asset pricing models to generate a high equity premium and a low risk-free rate while imposing realistic consumption dynamics. To address this issue, our paper proposes a novel pricing channel: we allow for consumption drops that can spark an economic crisis. This new feature generates a large equity premium even if possible consumption drops are of moderate size. In turn, our model also matches the consumption data of 42 countries along several dimensions. In particular, our approach generates a realistic number of crises that have realistic durations and involve clustering of moderate consumption drops.

Longevity Risk and Optimal Asset Allocation with Consumption and Investment Constraints

This paper investigates optimal retirement planning when investors desire to maintain a certain minimum level of consumption, which can be achieved only by a guaranteed income stream after retirement. Our model incorporates the subsistence level in consumption and social securities and defined-contribution retirement pensions, all of which are necessary to guarantee an income stream. Our model shows that the movements of the optimal risky investments might dramatically change with the subsistence level in consumption. Our numerical results show that the risky investment rate in the retirement pension can increase with the risk-free gross return rate and with the risk aversion level when the low risk-free rate and risk aversion level are both low. Furthermore, the risky investment rate in the retirement pension can decrease even when the market condition is favorable.