Relative Asset Prices Research Articles

Equity market connectedness across regimes of geopolitical risks: Historical evidence and theory

We use a threshold VAR model to capture the connectedness of the equity returns of the G7 in a regime-contingent manner as defined by low- and high-geopolitical risks (GPR). We find that connectedness is statistically stronger when GPR is at its higher rather than lower regime, but more importantly, this observation can be associated with the threat of adverse geopolitical events, rather than with their actual realization. To explain our empirical observations we employ a model of international trade in assets and international relative asset prices. We introduce uncertainty in future dividend payments combined with agents' ambiguity aversion to changes in the expected dividends. This allows us to model a geopolitical threat as a shock that affects the level of ambiguity about future dividends. At the same time, a geopolitical act is defined as a shock to the current period endowment of a given country, with limited effects on asset prices and returns. Our obtained results have important portfolio allocation implications for investors.

Causal analysis of central bank holdings of corporate bonds under interference

We investigate whether the transfer of corporate bonds from the private sector to the balance sheet of the central bank permanently alters their relative prices. Answering this question complements the literature on central bank asset purchase programs, documenting significant relative price changes over shorter horizons. We use data on bonds issued over the duration of the European Central Bank's corporate bond purchase program and a novel regression discontinuity design to quantify the causal effect of interest. The estimates indicate that the program did not, on average, permanently alter the yield spreads of eligible bonds relative to those of similar noneligible bonds. This finding suggests that central bank holdings of even relatively illiquid private sector securities can have no distortionary effects on the relative prices of such assets.

Cryptocurrencies Meet Equities: Risk Factors And Asset Pricing Relationships

Cryptocurrencies Meet Equities: Risk Factors And Asset Pricing Relationships

Cryptocurrencies Meet Equities: Risk Factors and Asset Pricing Relationships

We consider a variety of cryptocurrency and equity risk factors as potential forces that drive cryptocurrency returns and carry risk premiums. In a cross-section of 2,000 biggest cryptocurrencies, only downside market risk, cryptocurrency size and policy uncertainty factors are systematically priced with significant premiums. Momentum premium vanished in the recent years. Equity market risk appears to be more important than cryptocurrency market risk, suggesting greater linkages between cryptocurrency and equity markets than we used to think.

Monetary Policy and the Interest Rate: Reflections on Allan Meltzer's Contributions to Monetary Economics

The monetary framework developed by Karl Brunner and Allan Meltzer emphasized the interaction between the supply and demand for money and the supply and demand for credit. In a general equilibrium setting, the money market and the credit market jointly determine the short term interest rate and the price level of real assets. Open market operations change the composition of assets and, in turn, the price level of real assets and the interest rate. The effect of monetary policy on real activity depends on both the change in the interest rate and the change in the price level of real assets. The Brunner-Meltzer model therefore emphasizes the role of changes in relative prices of financial and real assets in response to changes in monetary policy. In recent years, the Federal Reserve has moved to a system that uses the interest rate on reserves as the primary tool of monetary policy. In doing so, the Federal Reserve has implicitly accepted the idea that monetary policy is entirely transmitted through the short term nominal interest rate. In this paper, I present Brunner and Meltzer's view of monetary transmission and their critique of monetary models that exclusively focus on the interest rate. In addition, I argue that the lack of evidence in support of the interest rate channel in conjunction with the change in the Federal Reserve's operating procedures presents an opportune time to revisit the Brunner-Meltzer critique.

A Reconsideration of the Equity Premium Puzzle

This paper develops a tractable asset pricing framework based on an Arrow Debreu economy with heterogeneous agents. The model re-casts a number of well known asset pricing relationships in terms of four underlying variables. The financial relationships studied here are the risk free rate, the market risk premium, a call option, the expected returns of individual securities, and the dividend growth model. The theoretical formulations are used to measure preference parameters in three different ways. The most precise estimates yield a value of relative risk aversion of 1.27, and a time preference discount rate of 3.82% per year.

Relative asset price bubbles

In models of financial bubbles, the price of a stock is typically unbounded, and this plays a fundamental role in the analysis of finite horizon local martingale bubbles. It would seem that price bubbles do not apply to a priori bounded risky asset prices, such as bond prices. To avoid this limitation, to characterize, and to identify bond price mispricings consistent with an absence of arbitrage, we develop the concept of a relative asset price bubble. This notion uses a risky asset’s price as the numeraire instead of the money market account’s value. This change of numeraire generates some interesting mathematical complexities because many important numeraires, including risky bonds, can vanish with positive probability over the model’s horizon.

The Rank Effect for Commodities

We uncover a large and significant low-minus-high rank effect for commodities across two centuries. There is nothing anomalous about this anomaly, nor is it clear how it can be arbitraged away. Using nonparametric econometric methods, we demonstrate that such a rank effect is a necessary consequence of a stationary relative asset price distribution. We confirm this prediction using daily commodity futures prices and show that a portfolio consisting of lower-ranked, lower-priced commodities yields 23% higher annual returns than a portfolio consisting of higher-ranked, higher-priced commodities. These excess returns have a Sharpe ratio nearly twice as high as the U.S. stock market yet are uncorrelated with market risk. In contrast to the extensive literature on asset pricing factors and anomalies, our results are structural and rely on minimal and realistic assumptions for the long-run properties of relative asset prices.

Risk-taking channels and capital inflows into the US treasuries

This letter explores dynamic interactions among capital inflows, asset prices, and leverage. A VAR model provides evidence that expansionary shocks to capital inflows into the US Treasuries lead to higher leverage by inducing appreciation in relative asset prices.

Distributional and welfare effects of Germany’s year 2000 tax reform: the context of savings and portfolio choice

This paper empirically investigates distributional and welfare effects of Germany’s year 2000 tax reform in the context of the household savings decision and the allocation of wealth to a portfolio of assets. The reform is simulated in an ex ante behavioural microsimulation approach. Behavioural responses resulting from changes in capital income taxation are estimated in an empirical demand model for household savings and asset allocation, which is applied to German survey data. Significant reductions in tax rates result in income gains for most of the households. Gains are found to be greater for households in higher tax brackets, whereby income inequality increases, in particular in East Germany. Moreover, households increase savings and alter the structure of asset demand as a result of shifts in relative asset prices. As a result, utility losses reduce welfare effects for almost all households, in particular for households with greater savings.

Eurosystem Collateral Policy and Framework — Post-Lehman Time as a New Collateral Space

Collateral plays a central role in monetary policy. In recent years, its importance has increased as uncollateralised inter-bank borrowing has gradually been replaced by collateralised central bank lending. This has in turn affected collateral availability and the need for high-quality assets. The European Central Bank has reacted to this development by creating a series of different measures to broaden collateral availability, including changing the eligibility rules (e.g. reducing rating thresholds for certain asset classes) or extending the eligible assets (e.g. allowing national central banks to accept bank loans as collateral). In the context of these developments, this article assesses and comments on various aspects of the Eurosystem collateral policy and overall framework. In particular, it examines the economic implications of the current ECB collateral policy for asset allocation and relative asset price developments from a cross-country perspective.

Relative Asset Price Bubbles

In models of financial bubbles, the price of a stock is a priori typically unbounded, and this plays a fundamental role in the analysis of finite horizon local martingale bubbles. It would seem that price bubbles do not apply to bounded risky asset prices, such as bond prices. To avoid this limitation, to characterize, and to identify bond price mispricings consistent with No Free Lunch with Vanishing Risk, we develop the concept of a relative asset price bubble. This notion uses a risky asset's price as the numeraire instead of the money market account's value. This change of numeraire generates some interesting mathematical complexities because some important numeraires, including risky bonds, can vanish with positive probability over the model's horizon.

Inflation Expectations, Business Taxation And The Incentive To Invest In Depreciable Capital Goods

A parochial issue in business taxation - one which was discussed vigorously during the U.S. 2007-2009 economic contraction is the issue of how corporate Federal income tax policy affects incentives for businesses to undertake new investments in capital goods. This paper focuses on the question of how the tax treatment of depreciation affects the incentives of business to invest in capital goods when businesses (rightly or wrongly) expect significant inflation during the depreciable life of the investment. An innovative idea of adjusting the system of tax depreciation for inflation is to allow an immediate deduction for the present value of the future economic depreciation that firms could claim if there were zero inflation. No adjustment for inflation would ever be needed because the depreciation charge would be taken in the same year in which the asset was purchased. The result of this approach is consistent with the result for inflation-adjusted historical cost depreciation because gains from changes in the relative prices of depreciable assets would be included in income.

Optimal portfolio choice and stochastic volatility

In this paper we examine the effect of stochastic volatility on optimal portfolio choice in both partial and general equilibrium settings. In a partial equilibrium setting we derive an analog of the classic Samuelson–Merton optimal portfolio result and define volatility-adjusted risk aversion as the effective risk aversion of an individual investing in an asset with stochastic volatility. We extend prior research which shows that effective risk aversion is greater with stochastic volatility than without for investors without wealth effects by providing further comparative static results on changes in effective risk aversion due to changes in the distribution of volatility. We demonstrate that effective risk aversion is increasing in the constant absolute risk aversion and the variance of the volatility distribution for investors without wealth effects. We further show that for these investors a first-order stochastic dominant shift in the volatility distribution does not necessarily increase effective risk aversion, whereas a second-order stochastic dominant shift in the volatility does increase effective risk aversion. Finally, we examine the effect of stochastic volatility on equilibrium asset prices. We derive an explicit capital asset pricing relationship that illustrates how stochastic volatility alters equilibrium asset prices in a setting with multiple risky assets, where returns have a market factor and asset-specific random components and multiple investor types. Copyright © 2011 John Wiley & Sons, Ltd.

Jump-Diffusion Models with Correlated Brownian Motion and Compound Poisson Processes

In this paper we provide a closed form option pricing model with underlying uncertainty modeled as an exponential Levy process. The stochastic structure of our model relaxes the restrictive assumption of zero covariance between the Brownian motion and Poisson process jump size found in all traditional jump-diffusion models. The resulting equity diffusion and jump risk premia of the equilibrium consumption capital asset pricing relationship are non-linear functions of time. The option pricing model is developed using Rubinstein’s method of pricing by substitution in equilibrium and it is shown that the sign and magnitude of this covariance plays a crucial role in determining the slope of the implied volatility term structure.

Forced Portfolio Liquidation

We study the problem of a leveraged investor that is forced to unwind a significant fraction of its portfolio in a collection of illiquid markets. It is shown that markets may become disrupted in response to a relatively small liquidity shock. As a consequence, the probability of default can be much higher than suggested by standard risk measures. We also study the impact of successful liquidation on relative asset prices. Our analysis suggests that effective risk management of leveraged financial entities should focus on the entity's potential to generate emergency cash-flows net of third-party claims for liquidity.

Dynamic General Equilibrium andT-Period Fund Separation

AbstractIn a dynamic general equilibrium model, we derive conditions for a mutual fund separation property by which the savings decision is separated from the asset allocation decision. With logarithmic utility functions, this separation holds for any heterogeneity in discount factors, while the generalization to constant relative risk aversion holds only for homogeneous discount factors but allows for any heterogeneity in endowments. The logarithmic case provides a general equilibrium foundation for the growth-optimal portfolio literature. Both cases yield equilibrium asset pricing formulas that allow for investor heterogeneity, in which the return process is endogenous and asset prices are determined by expected discounted relative dividends. Our results have simple asset pricing implications for the time series as well as the cross section of relative asset prices. It is found that on data from the Dow Jones Industrial Average, a risk aversion smaller than in the logarithmic case fits best.

Distributional and Welfare Effects of Germany's Year 2000 Tax Reform

This paper empirically investigates distributional and welfare effects of Germany's year 2000 income tax reform. The reform is simulated in an ex-ante behavioral microsimulation approach. Dead weight loss of changes in capital income taxation is estimated in a structural model for household savings and asset demand applied to German survey data. Significant reductions in tax rates result in income gains for most of the households. Gains are found greater for households in higher tax brackets, whereby income inequality increases, slightly greater in East- than in West-Germany. Moreover, households increase savings and alter the structure of asset demand as a result of shifts in relative asset prices. As a consequence, utility losses reduce welfare effects for almost all households.

OPTION BETAS: RISK MEASURES FOR OPTIONS

This paper deals with the problem of determining the correct risk measure for options in a Black–Scholes (BS) framework when time is discrete. For the purposes of hedging or testing simple asset pricing relationships previous papers used the "local", i.e., the continuous-time, BS beta as the measure of option risk even over discrete time intervals. We derive a closed-form solution for option betas over discrete return periods where we distinguish between "covariance betas" and "asset pricing betas". Both types of betas involve only simple Black–Scholes option prices and are thus easy to compute. However, the theoretical properties of these discrete betas are fundamentally different from those of local betas. We also analyze the impact of the return interval on two performance measures, the Sharpe ratio and the Treynor measure. The dependence of both measures on the return interval is economically significant, especially for OTM options.

Asset Allocation Challenges for Pension Funds

Pension funds have become the largest class of investors in many markets and, given their size, the allocation of their assets has important implications for the relative prices of financial assets. There may be a trend shift of private (defined benefit) pension fund asset allocation strategies away from equity to bonds, especially to government bonds, given their limited credit risk. The potential demand for such bonds could, in principle, be very substantial, sufficient in fact to result in a scarcity of such bonds in circulation. Many debt managers have taken advantage of current bond market conditions and issued long-term to ultra-long-term bonds. But whether they should follow a strategy of maturity-lengthening with the express aim to facilitate the task for pension fund managers is a different matter. Most policy makers would not recommend that governments undertake to issue long-term debt with the express intent of meeting this demand, not least because they expect the price mechanism to clear apparent imbalances in asset markets.