Stock Markets and Asset Pricing

‘Macroeconomics Uncertainty Prices, Uncertainty Prices when Beliefs are Tenuous’ Sargent, T. (with L. Hansen), 2019.

A representative investor does not know which member of a set of well-defined parametric “structured models” is best. The investor also suspects that all of the structured models are misspecified. These uncertainties about probability distributions of risks give rise to components of equilibrium prices that differ from the risk prices widely used in asset pricing theory. A quantitative example highlights a representative investor’s uncertainties about the size and persistence of macroeconomic growth rates. Our model of preferences under ambiguity puts nonlinearities into marginal valuations that induce time variations in market prices of uncertainty. These arise because the representative investor especially fears high persistence of low growth rate states and low persistence of high growth rate states.

‘Twisted Probabilities, Uncertainty, and Prices’ Sargent, T. (with L. Hansen, B. Szoke, and LL. Han), 2019.

A decision maker constructs a convex set of nonnegative martingales to use as likelihood ratios that represent alternatives that are statistically close to a decision maker’s baseline model. The set is twisted to include some specific models of interest. Maxmin expected utility over that set gives rise to equilibrium prices of model uncertainty expressed as worst-case distortions to drifts in a representative investor’s baseline model. Three quantitative illustrations start with baseline models having exogenous long-run risks in technology shocks. These put endogenous long-run risks into consumption dynamics that differ in details that depend on how shocks affect returns to capital stocks. We describe sets of alternatives to a baseline model that generate countercyclical prices of uncertainty.

‘Characteristics of Mutual Fund Portfolios:
Where Are the Value Funds?’ Ludvingson, S. (with M. Lettau, and P. Manoel), 2018.

This paper provides a comprehensive analysis of portfolios of active mutual funds, ETFs and hedge funds through the lens of risk (anomaly) factors. We show that that these funds do not systematically tilt their portfolios towards profitable factors, such as high book-to-market (BM) ratios, high momentum, small size, high profitability and low investment growth. Strikingly, there are almost no high-BM funds in our sample while there are many low-BM “growth” funds. Portfolios of “growth” funds are concentrated in low BM-stocks but “value” funds hold stocks across the entire BM spectrum. In fact, most “value” funds hold a higher proportion of their portfolios in low-BM (“growth”) stocks than in high-BM (“value”)
stocks. While there are some micro/small/mid-cap funds, the vast majority of mutual funds hold very large stocks. But the distributions of mutual fund momentum, profitability and investment growth are concentrated around market average with little variation across funds. The characteristics distributions of ETFs and hedge funds do not differ significantly from those of mutual funds. We conclude that the characteristics of mutual fund portfolios raises a number of questions about why funds do not exploit well-known return premia and how their portfolio choices affects asset prices in equilibrium. reliability in finite samples.

‘Empirical Evaluation of Overspecified Asset Pricing Models’ Manresa, E. (with F. Penaranda, and E. Sentana), 2017.

Asset pricing models with potentially too many risk factors are increasingly commonin empirical work. Unfortunately, they can yield misleading statistical inferences. Unlikeother studies focusing on the properties of standard estimators and tests, we estimate thesets of SDFs and risk prices compatible with the asset pricing restrictions of a given model. We also propose tests to detect problematic situations with economically meaningless SDFsuncorrelated to the test assets. We conÖrm the empirical relevance of our proposed estimatorsand tests with Yogoís (2006) linearized version of the consumption CAPM, and provide MonteCarlo evidence on their reliability in finite samples.

‘On Interest Rate Policy and Asset Bubbles’ Gale, D. (with F. Allen, and G. Barlevy), 2017.

In a provocative paper, Gali (2014), showed that a policymaker who raises interest rates to rein in a potential bubble will only make a bubble bigger if one exists. This poses a challenge to advocates of lean-against-the-wind policies that call for raising interest rates to mitigate potential bubbles. In this paper, we argue there are situations in which the lean-against-the wind view is justified. First, we argue GalÌís framework abstracts from the possibility that a policymaker who raises rates will crowd out resources that would have otherwise been spent on the bubble. Once we modify Galiís model to allow for this possibility, policymakers can intervene in ways that raise interest rates and dampen bubbles. However, there is no reason policymakers should intervene to dampen the bubble in this case, since the bubble that arises in Gali’s setup is not one that society would be better o§ without. We then further modify Gali’s model to generate the type of credit-driven bubbles that alarm policymakers, and argue
there may be justification for intervention in that case.

‘Windfall Gains and Stock Market Participation,’ Cesarini, D. (with J.S Briggs, E. Lindqvist, and R. Östling), 2015.

We estimate the causal effect of wealth on stock market participation using administrative data on Swedish lottery players. A $150,000 windfall gain increases stock ownership probability among pre-lottery non-participants by 12 percentage points, while pre-lottery stock holders are unaffected. The effect is immediate, seemingly permanent and heterogeneous in intuitive ways. Standard lifecycle models predict wealth effects far too large to match our causal estimates under common calibrations. Additional analyses suggest a limited role for explanations such as procrastination or real-estate investment. Overall, results suggest that “nonstandard” beliefs or preferences contribute to the nonparticipation of households across many demographic groups.

‘Equilibrium Corporate Finance and Intermediation,’ Bisin, A. (with P. Gottardi, and G. Clementi), 2017.

This paper analyzes a class of competitive economies with production, incomplete financial markets, and agency frictions. Since markets are incomplete, firms choose their capital structure – and, to some extent, their investment – to satisfy investors’ hedging needs. This class of economies generates interesting implications for investment in physical capital, leverage, corporate bond spreads, as well as excess equity returns. Even though markets are incomplete, we show that an objective function of the firm is generally defined such that shareholders always unanimously support firms’ choices. Furthermore, with no agency frictions competitive equilibria are constrained efficient.

‘Windfall Gains and Stock Market Participation,’ Cesarini, D. (with J.S Briggs, E. Lindqvist, and R. Östling), 2015.

We estimate the causal effect of wealth on stock market participation using administrative data on Swedish lottery players. A $150,000 windfall gain increases stock ownership probability among pre-lottery non-participants by 12 percentage points, while pre-lottery stock holders are unaffected. The effect is immediate, seemingly permanent and heterogeneous in intuitive ways. Standard lifecycle models predict wealth effects far too large to match our causal estimates under common calibrations. Additional analyses suggest a limited role for explanations such as procrastination or real-estate investment. Overall, results suggest that “nonstandard” beliefs or preferences contribute to the nonparticipation of households across many demographic groups.

‘Sovereign Debt, Domestic Banks, and the Provision of Public Liquidity,’ Perez, D., 2015.

This paper explores two mechanisms through which a sovereign default can disrupt the domestic economy via its banking system. First, a default creates a negative balance sheet effect on banks, which prevents the flow of resources to productive investments. Second, default undermines internal liquidity as banks replace government securities with less productive investments. A quantitative analysis of the model shows that these mechanisms generate a deep and persistent fall in output post-default, which accounts for the government’s commitment necessary to explain observed levels of external public debt. The model is used to study policies that address the government’s lack of commitment.

‘ The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth’s Consistency Constraint in Modelling Aggregate Outcomes,’ Frydman, R. (with S. Johansen, A. Rahbek, and M.N. Tabor) , 2019.

We introduce the Qualitative Expectations Hypothesis (QEH) as a new approach to modeling macroeconomic and financial outcomes. Building on John Muth’s seminal insight underpinning the Rational Expectations Hypothesis (REH), QEH represents the market’s forecasts to be consistent with the predictions of an economist’s model. However, by assuming that outcomes lie within stochastic intervals, QEH, unlike REH, recognizes the ambiguity faced by an economist and market participants alike. Moreover, QEH leaves the model open to ambiguity by not specifying a mechanism determining specific values that outcomes take within these intervals. In order to examine a QEH model’s empirical relevance, we formulate and estimate its statistical analog based on simulated data. We show that the proposed statistical model adequately represents an illustrative sample from the QEH model. We also illustrate how estimates of the statistical model’s parameters can be used to assess the QEH model’s qualitative implications.

‘ How Fundamentals Drive Forecasts of Stock Returns: Uncovering the Role of Market Sentiments,’ Frydman, R. (with N. Mangee, J. Stillwagon) , 2019.

We reveal a novel channel through which market sentiment influences how participants forecast stock returns: their optimism and pessimism affect how they interpret news about fundamentals. Although the rational expectations hypothesis and behavioral finance are irreconcilable on logical grounds, our findings thus highlight the relevance of the insights underpinning both of these milestone approaches. We also find that market sentiment influences stock returns highly irregularly, both in timing and magnitude, which supports recent theoretical approaches recognizing that economists as well as market participants face ambiguity about the correct model driving stock returns.

‘Intermediation as Rent Extraction,’ Menzio, G. (with M. Farboodi, G. Jarosch), 2017.

We propose a theory of intermediation as rent extraction, and explore its implications for the extent of intermediation, welfare and policy. A frictional asset market is populated by agents who are heterogeneous with respect to their bargaining skills, as some can commit to take-it-or-leave-it offers and others cannot. In equilibrium, agents with commitment power act as intermediaries and those without act as final users. Agents with commitment trade on behalf of agents without commitment to extract more rents from third parties. If agents can invest in a commitment technology, there are multiple equilibria differing in the fraction of intermediaries. Equilibria with more intermediaries have lower welfare and any equilibrium with intermediation is inefficient. Intermediation grows as trading frictions become small and during times when interest rates are low. A simple transaction tax can restore efficiency by eliminating any scope for bargaining.

‘Dispersion and Skewness of Bid Prices,’ Jovanovic, B. (with A.J. Menkeveld), 2015.

Competitive bidding by homogeneous agents in a first-price auction could yield a non-degenerate bid price distribution. This price dispersion is the unique equilibrium in a setting where bidders “pay to play.” Ex ante, bidders decide simultaneously on whether to play or not. Ex post, those who play submit their bid simultaneously not knowing who else is in the market. The price-dispersion result is applied to high-frequency bidding in limit-order markets. The parsimonious model fits the bid price dispersion for S&P 500 stocks remarkably well.

‘Trading on Sunspots,’ Jovanovic, B. (with V. Tsyrennikov), 2015.

In a model with multiple Pareto-ranked equilibria we endogenize the equilibrium selection probabilities by adding trade in assets that pay based on the realization of a sunspot. Asset trading imposes restrictions on the equilibrium set in a way that raises welfare. When the probability of a low-output outcome is high enough, the coordination game becomes more like a prisoner’s dilemma in which the high-output equilibrium disappears because of the asset positions that agents trade towards induce some agents not to invest. We derive an upper bound on the probabilities of the low-output equilibrium that we interpret as a disaster. We derive asset pricing implications including the disaster premium, and we study the effect on stock prices of news shocks to beliefs.

‘Monetary Policy and Asset Valuation,’ Ludvigson, S.C. (with F. Bianchi and M. Lettau), 2018.

We find evidence of infrequent shifts, or “regimes,” in the mean of the asset valuation variable cay_t that are strongly associated with low-frequency fluctuations in the real federal funds rate, with low policy rates associated with high asset valuations, and vice versa. There is no evidence that infrequent shifts to high asset valuations are associated with higher expected economic growth or lower economic uncertainty; indeed, the opposite is true. Additional evidence shows that regimes of low interest rates and high asset valuations are characterized by lower equity market risk premia and monetary policy that is less responsive to inflation.

‘Origins of Stock Market Fluctuations,’ Ludvigson, S.C. (with D.L. Greenwald and M. Lettau), 2016.

Three mutually uncorrelated economic disturbances that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952. A model is employed to interpret these disturbances in terms of three latent primitive shocks. In the short run, shocks that affect the willingness to bear risk independently of macroeconomic fundamentals explain most of the variation in the market. In the long run, the market is profoundly affected by shocks that reallocate the rewards of a given level of production between workers and shareholders. Productivity shocks play a small role in historical stock market fluctuations at all horizons.

‘Structured Uncertainty and Model Misspecification∗,’ Sargent, T. (with L.P. Hansen), 2019.

An ambiguity averse decision maker evaluates plans under a restricted family of structured models and unstructured alternatives that are statistically close to them. Structured models include parametric models in which parameter values vary over time in ways that the decision maker cannot describe probabilistically. Because he suspects that all parametric models are misspecified, the decision maker also evaluates plans under alternative probability distributions with much less structure.

‘Prices of Macroeconomics Uncertainties with Tenuous Beliefs,’ Sargent, T. (with L.P. Hansen), 2017.

A dynamic extension of max-min preferences allows a decision maker to consider both a parametric family of what we call structured models and unstructured alternatives that are statistically close to them. The decision maker suspects that parameter values vary over time in unknown ways that he cannot describe probabilistically. Because he suspects that all of these parametric models are misspecified, he evaluates decisions under alternative probability distributions with much less structure. We characterize equilibrium uncertainty prices by confronting a representative investor with a portfolio choice problem. We offer a quantitative illustration that focuses on the investor’s uncertainty about the size and persistence of macroeconomic growth rates. Nonlinearities in marginal valuations induce time variations in market prices
of uncertainty. Prices of uncertainty fluctuate because a representative investor especially fears high persistence in bad states and low persistence in good ones.