Simple Asset Research Articles

Does Money Help to Rescue the Consumption-CAPM?

This paper offers a simple macroeconomic asset pricing model that extends the consumption model by adding the growth in real money balances as a risk factor. The results from Euler equations estimation show that the monetary model improves significantly the baseline model in terms of pricing errors. Yet, the parameter estimates are economically implausible in most cases. Specifically, the estimates for the share of money in the utility function are very large in economic terms. The results for a linear version of the monetary model show that it cannot outperform the standard CCAPM in explaining cross-sectional risk premia.

A Simple Asset Pricing Model with Heterogeneous Agents, Uninsurable Labor Income and Limited Stock Market Participation

In this paper we study a simple two-period asset pricing model to understand the implications of uninsurable labor income risk and/or borrowing constraints, limited stock market participation, heterogeneous labor income volatilities, and heterogeneous preferences. We appraise the performance of each of these in matching moments of asset returns to the data and show that limited stock market participation generates a significantly large equity premium. We also show that the distribution of wealth between stock market participants and non-participants plays an important role in asset pricing, and that the effect of borrowing constraints on asset returns are similar to that of limited participation. Finally, we discuss the practical implications of our investigation, providing an appraisal of ongoing changes in asset returns.

Information Processing Constraints and Asset Mispricing

I analyse a series of natural quasi-experiments - centred on betting exchange data on the Wimbledon Tennis Championships - to determine whether information processing constraints are partially responsible for mispricing in asset markets. I find that the arrival of information during each match leads to substantial mispricing between two equivalent assets, and that part of this mispricing can be attributed to differences in the frequency with which the two prices are updated inplay. This suggests that information processing constraints force the periodic neglect of one of the assets, thereby causing substantial, albeit temporary, mispricing in this simple asset market.

Can consumption-based asset pricing models using monetary conditioning variables explain the cross-section of German stock returns?

In this article, we analyse whether simple Consumption-based Capital Asset Pricing Models (CCAPMs) using monetary conditioning information (growth of the money aggregates M1, M2 and M3) can explain the cross-section of German size, book-to-market and industry portfolio returns. Our results show that models having stochastic discount factor parameters that vary with money aggregates can reduce the pricing errors of models with constant parameters. However, a large proportion of the cross-sectional variation remains unexplained.

Asset price dynamics with heterogeneous beliefs and local network interactions

In this paper we investigate the effects of network topologies on asset price dynamics. We introduce network communications into a simple asset pricing model with heterogeneous beliefs. The agents may switch between several belief types according to their performance. The performance information is available to the agents only locally through their own experience and the experience of other agents directly connected to them. We model the communications with four commonly considered network topologies: a fully connected network, a regular lattice, a small world, and a random graph. The results show that the network topologies influence asset price dynamics in terms of the regions of stability, amplitudes of fluctuations and statistical properties.

Asset Price Dynamics with Heterogeneous Beliefs and Local Network Interactions

In this paper we investigate the effects of network topologies on asset price dynamics. We introduce network communications into a simple asset pricing model with heterogeneous beliefs. The agents may switch between several belief types according to their performance. The performance information is available to the agents only locally through their own experience and the experience of other agents directly connected to them. We model the communications with four commonly considered network topologies: a fully connected network, a regular lattice, a small world, and a random graph. The results show that the network topologies influences asset price dynamics in terms of the regions of stability, amplitudes of fluctuations and statistical properties.

Empirical Asset Pricing with Nonlinear Risk Premia

We introduce a new model for the joint dynamics of the S&P 100 index and the VXO implied volatility index. The nonlinear specification of the variance process is designed to simultaneously accommodate extreme persistence and strong mean reversion. This grants superior forecasting power over the standard (linear) specifications for implied variance forecasting. We obtain statistically significant predictions in an out-of-sample exercise spanning several market crashes starting 1986 and including the recent subprime crisis. The model specification is possible through a simple continuous-time no-arbitrage asset pricing framework that combines semi-analytic pricing with a nonlinear specification for the market price of risk.

Broker-Dealer Risk Appetite and Commodity Returns

This paper shows that the risk-bearing capacity of U.S. securities brokers and dealers is a strong determinant of risk premia in commodity markets. Commodity derivatives are the principal instrument used by producers and consumers of commodities to hedge against commodity price risk. Broker-dealers play an important role in this hedging process because commodity derivatives are traded primarily over the counter. I capture the limits of arbitrage in this market in a simple asset pricing model where producers and consumers of commodities share risk with broker-dealers who are subject to funding constraints. In equilibrium, the price of aggregate commodity risk decreases in the relative leverage of the broker-dealer sector. I estimate the model in the cross-section of commodities and find strong empirical support for its predictions. Fluctuations in risk-bearing capacity have particularly strong forecasting power for energy returns, both in sample and out of sample.

Broker-Dealer Risk Appetite and Commodity Returns

This paper shows that the risk-bearing capacity of security brokers and dealers is a strong determinant of risk premia and return volatility in commodity markets. I measure risk-bearing capacity as the fraction of brokerdealer …nancial assets relative to the total …nancial assets of broker-dealers and households. This variable has particularly strong forecasting power for energy returns, both in-sample and out-of-sample: it forecasts approximately 30% of the variation in quarterly crude oil returns. I rationalize the …ndings in a simple asset pricing model where the economic role of broker-dealers is to provide insurance against commodity price ‡uctuations. I estimate cross-sectional prices of risk using an arbitrage-free asset pricing approach and show that broker-dealer risk-bearing capacity forecasts commodity returns because of its association with the price of risk.

Evaluations of Risk Measures for Different Probability Measures

Stochastic optimization problems, which arise in different areas, such as simple asset allocation problems or problems in insurance, often involve coherent risk measures. In these real-world problems the considered risk measure is frequently built on empirical distributions. It is therefore of interest to understand the potential deviation, which occurs when evaluating a risk measure for a perturbed, or slightly changed, probability measure. This paper addresses the potential deviation. It turns out that the Wasserstein distance, a well-known distance for probability measures, provides a valuable notion of distance in the present context: Many risk measures allow a precise quantification in terms of the Wasserstein distance, and important risk measures are continuous with respect to this distance. For specific random variables, which often occur in concrete, real-world problems, it is moreover demonstrated that the derived constants, describing the continuity properties, cannot be improved. The associated...

Primary commodity prices: Co-movements, common factors and fundamentals

The behavior of commodities is critical for developing and developed countries alike. This paper contributes to the empirical evidence on the co-movement and determinants of commodity prices. Using nonstationary panel methods, we document a statistically significant degree of co-movement due to a common factor. Within a Factor Augmented VAR approach, real interest rate and uncertainty, as postulated by a simple asset pricing model, are both found to be negatively related to this common factor. This evidence is robust to the inclusion of demand and supply shocks, which both positively impact on the co-movement of commodity prices.

Does Social Interaction Destablise Financial Markets?

With this paper, I propose a simple asset pricing model that accounts for the influence from social interaction. Investors are assumed to make up their mind about an asset’s price based on a forecasting strategy and its past profitability as well as on the contemporaneous expectations of other market participants. Empirically analysing stocks of the DAX30 index, I provide evidence that social interaction rather destabilises financial markets. Based on my results, I state that at least, it does not have a stabilising effect.

Money and risk of loss in an asset market segmentation model

A simple asset market segmentation model is constructed to study the relationship between inflation and theft when money is the only medium of exchange. In equilibrium, money is nonneutral and monetary policy has asymmetric effects on theft, real money holding, and consumption. The distributional effects persist over periods and the liquidity effect may arise. Next, given the asymmetric effects of monetary policy, the crime rates differ across economic individuals in order to smooth out consumption fluctuations. Given the conditions of stealing technology, monetary equilibrium would not be always sustainable. Finally, the optimal money growth rate is to minimize theft and the Friedman rule is suboptimal.

Financial Literacy, Information Acquisition and Asset Pricing Implications

In this paper I study the information acquisition process in a simple asset pricing model with heterogeneous beliefs about future prices. This is instrumental to investigate the effects of financial literacy on market volatility. I posit that financial literacy affects the cost of acquiring information on the asset payoff and show that the effect on the market volatility is non-monotone and depends on the uncertainty of the fundamentals. I conclude that policies aimed at reducing the financial information acquisition cost increase price informativeness and, in a scenario with high uncertainty of the fundamentals, reduce the market volatility. The main intuition is that lower information cost for the less literate households leads them to acquire more private information and to trade more actively. Having more private information revealed by the market price affects positively market volatility. On the other hand, with low uncertainty in the fundamental, the positive marginal effect is offset by the negative effect of having more traders with less precise beliefs.

Ambiguity and the Cross-Section of Stock Returns

We derive a simple capital asset pricing model under Knightian uncertainty or model ambiguity by solving a static constrained robust control problem. We show that under the reference or approximating model the resulting “Beta form” regression displays intercepts (or alphas) that reflect each asset’s relative ambiguity (with respect to the market). Under the “worst-case” scenario however, the usual CAPM obtains. Consistent with this view and the well-known fact that the empirical test of the CAPM is an ill-posed problem, we introduce a novel estimation method based on “entropy” as proxy of investors’ state of knowledge. We show that the “ambiguity” component of the equity premium is statistically and economically significant with an average size commensurable with the usual risk premium. The results are robust to different time periods, rolling regression windows, and sample of test assets. Finally, we discuss the role of book-to-market and size as proxies of investors’ concern to model ambiguity in the stock market.

Converse trading strategies, intrinsic noise and the stylized facts of financial markets

This paper proposes a simple asset pricing model with three groups of traders: chartists who believe in the persistence of bull and bear markets, fundamentalists who bet on a reduction of the observed mispricing, and investors who follow a buy-and-hold strategy. The innovative feature of the model concerns the frequency of trading: rather than remaining constant over time, each agent in a group is only assumed to become active with a certain probability over a given market period. Depending on the trading strategy, part of this elementary kind of intrinsic noise is additive and another part is multiplicative. Using bootstrap and Monte Carlo methods, it is demonstrated that this combination can contribute to explaining the stylized facts of the daily returns on financial markets, such as volatility clustering, fat tails, and the autocorrelation patterns.

The Pricing of Growth Opportunity and Stock Market Liquidity

This study presents a simple asset pricing model with liquidity, short-run earnings growth, and long-run growth opportunity as risk factors and with the presence of transaction costs. The model provides a framework for understanding the channel through stock market liquidity affects asset prices by aligning growth opportunity. Empirical results suggest that the return sensitivity to growth and liquidity sensitivity to growth appear to be the most important sources of risks in determining the asset prices. Furthermore, the Granger causality test suggests the systematic liquidity variation through the business cycle is related to the growth opportunity. Liquid stock recover faster than illiquid stocks in response to the upcoming growth opportunity by the end of market downturns and therefore illiquid stocks that are unable to respond to growth opportunity are riskier in face of market shocks. Overall, the findings of this paper shed light on a new channel which liquidity risk affect asset prices and complement the mechanism of “flight to quality”.

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Investment-Specific Shocks and Momentum Profits

This paper explores the relationship between investment-specific shocks (i.e., technological innovations in equipment and software), firm investment, and momentum profits. Empirically, momentum profits comove positively with investment-specific shocks with a correlation coefficient of 0.32. An unconditional two-factor model, with investment-specific shocks and market excess returns as the risk factors, explains 90% of the average returns of momentum portfolios. Consistent with investment dynamics, I propose a rational explanation for momentum profits: Past winners are those who had good idiosyncratic productivity in the recent past; they initiate more investment, make greater investment commitments, and hence have a higher risk exposure to investment-specific shocks than past losers. A simple investment-based asset pricing model is developed to elaborate this story, with the key ingredients of investment commitment and investment-specific shocks. The model generates reasonably large momentum profits and investment dynamics of momentum portfolios as in the data.

Composition of an efficient portfolio in the Bielecki and Pliska market model

We study the continuous time portfolio optimization model due to Bielecki and Pliska where the mean returns of individual securities or asset categories are explicitly affected by underlying economic factors. We introduce the functional Qγ featuring the expected earnings yield of portfolio minus a penalty term proportional with a coefficient γ to the variance when we keep the value of the factor levels fixed. The coefficient γ plays the role of a risk-aversion parameter. We find the optimal trading positions that can be obtained as the solution to a maximization problem for Qγ at any moment of time. The single-factor case is analyzed in more details. We present a simple asset allocation example featuring a Vasicek-type interest rate which affects a stock index and also serves as a second investment opportunity. Then we compare our results with the theory of Bielecki and Pliska where the authors employ the methods of the risk-sensitive control theory thereby using an infinite horizon objective featuring the long run expected growth rate, the asymptotic variance, and a risk-aversion parameter similar to γ.