Browsing by Author "Bansal, Ravi"

The three essays in this dissertation explore the role of fluctuations in aggregate volatility and global temperature as sources of systemic risk.

The first essay proposes a production-based asset pricing model and provides empirical evidence suggesting that compensation for volatility risk is closely related to an unexplored characteristic of a firm, namely, its reliance on skilled labor. I propose a model in which aggregate growth has time-varying volatility, and linear adjustment costs in labor increase with the skill of a worker. The model predicts that expected returns increase with a firm's reliance on skilled labor, as well as compensation for fluctuations in aggregate uncertainty. Consequently, a rise in aggregate uncertainty predicts an increase in expected returns as well as in cautiousness in hiring and firing. This impact is larger for firms with a high share of skilled workers because their labor is more costly to adjust. I empirically test the implications of the model using occupational estimates to construct a measure of a firm's reliance on skilled labor, and find a positive and statistically significant cross-sectional relation between the reliance on skilled labor and expected returns. Empirical estimates also show that an increase in aggregate uncertainty leads to a rise in expected returns, and this impact is larger for firms which rely heavily on skilled labor; thereby, a firm's exposure to aggregate volatility is positively related to its reliance on skilled labor.

In the second and third essay, co-authored with Ravi Bansal, we explore the impact of global temperature on financial markets and the macroeconomy. In tho second essay we explore if temperature is an aggregate risk factor that adversely affects economic growth. First, using data on global capital markets we find that the risk-exposure of these returns to temperature shocks, i.e., their temperature beta, is a highly significant variable in accounting for cross-sectional differences in expected returns. Second, using a panel of countries we show that GDP growth is negatively related to global temperature, suggesting that temperature can be a source of aggregate risk. To interpret the empirical evidence, we present a quantitative consumption-based long-run risks model that quantitatively accounts for the observed cross-sectional differences in temperature betas, the compensation for temperature risk, and the connection between aggregate growth and temperature risks.

The last essay proposes a general equilibrium model that simultaneously models the world economy and global climate to understand the impact of climate change on the economy. We use this model to evaluate the role of temperature in determining asset prices, and to compute utility-based welfare costs as well as dollar costs of insuring against temperature fluctuations. We find that the temperature related utility-costs are about 0.78% of consumption, and the total dollar costs of completely insuring against temperature variation are 2.46% of world GDP. If we allow for temperature-triggered natural disasters to impact growth, insuring against temperature variation raise to 5.47% of world GDP.

The central puzzles in financial economics commonly include

violations of the expectations hypotheses, predictability of excess returns, and the levels and volatilities of nominal bond yields, in addition to well-known equity premium and the risk-free rate puzzles.

Equally surprising is the recent evidence on large moves in asset prices, and the over-pricing of the out-of-the-money index put options relative to standard models. In this work, I argue that the long-run risks type model can successfully explain these features of financial markets. I present robust empirical evidence which supports the main economic channels in the model. Finally, I develop econometric methods to estimate and test the model, and find that it delivers plausible preference and model parameters and provides a good fit to the asset-price and macroeconomic data.

In the first chapter, which is co-authored with Ravi Bansal, we present a long-run risks based equilibrium model that can quantitatively explain the violations of expectations hypotheses and predictability of returns in bond and currency markets. The key ingredients of the model include a low-frequency predictable component in consumption, time-varying consumption volatility and investor's preferences for early resolution of uncertainty. In this model, varying consumption volatility in the presence of the predictable consumption component leads to appropriate variation in bond yields and the risk premia to provide an explanation for the puzzling violations of the expectations hypothesis. Using domestic and foreign consumption and asset markets data we provide direct empirical support for the economic channels highlighted in the paper.

In the second chapter, co-authored with Ravi Bansal, we develop a general equilibrium model in which income and dividends are smooth, but asset prices are subject to large moves (jumps). A prominent feature of the model is that the optimal decision of investors to learn the unobserved state triggers large asset-price jumps. We show that the learning choice is critically determined by preference parameters and the conditional volatility of income process. An important prediction of the model is that income volatility predicts future jumps, while the variation in the level of income does not. We find that indeed in the data large moves in returns are predicted by consumption volatility, but not by the changes in the consumption level. In numerical calibrations, we show that the model can quantitatively capture these novel features of the data.

In the third chapter, I present a long-run risks type model where consumption shocks are Gaussian, and the agent learns about unobserved expected growth from the cross-section of signals. The uncertainty about expected growth (confidence measure), as in the data, is time-varying and subject to jump-like risks. I show that the confidence jump risk channel can quantitatively account for the option price puzzles and large moves in asset prices, without hard-wiring jumps into consumption. Based on two estimation approaches, the model provides a good fit to the option price, confidence measure, returns and consumption data, at the plausible preference and model parameter values.

In my dissertation, I study the link between economic growth and asset prices in stochastic endogenous growth models. In these settings, long-term growth prospects are endogenously determined by innovation and R\&D. In equilibrium, R\&D endogenously drives a small, persistent component in productivity which generates long-run uncertainty about economic growth. With recursive preferences, this growth propagation mechanism helps reconcile a broad spectrum of equity and bond market facts jointly with macroeconomic fluctuations.

My dissertation, consisting of three related essays, aims to understand the role of macroeconomic risks in the stock and bond markets. In the first chapter, I build a financial intermediary sector with a leverage constraint a la Gertler and Kiyotaki (2010) into an endowment economy with an independently and identically distributed consumption growth process and recursive preferences. I use a global method to solve the model, and show that accounting for occasionally binding constraint is important for quantifying the asset pricing implications. Quantitatively, the model generates a procyclical and persistent variation of price-dividend ratio, and a high and countercyclical equity premium. As a distinct prediction from the model, in the credit crunch, high TED spread, due to a liquidity premium, coincides with low stock price and high stock market volatility, a pattern I confirm in the data.

In the second chapter, which is coauthored with Hengjie Ai and Mariano Croce, we model investment options as intangible capital in a production economy in which younger vintages of assets in place have lower exposure to aggregate productivity risk. In equilibrium, physical capital requires a substantially higher expected return than intangible capital. Quantitatively, our model rationalizes a significant share of the observed difference in the average return of book-to-market-sorted portfolios (value premium). Our economy also produces (1) a high premium of the aggregate stock market over the risk-free interest rate, (2) a low and smooth risk-free interest rate, and (3) key features of the consumption and investment dynamics in the U.S. data.

In the third chapter, I study the joint determinants of stock and bond returns in Bansal and Yaron (2004) long-run risks model framework with regime shifts in consumption and inflation dynamics -- in particular, the means, volatilities, and the correlation structure between consumption growth and inflation are regime-dependent. This general equilibrium framework can (1) generate time-varying and switching signs of stock and bond correlations, as well as switching signs of bond risk premium; (2) quantitatively reproduce various other salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curve, the violation of expectations hypothesis of bond returns. The model shows that term structure of interest rates and stock-bond correlation are intimately related to business cycles, while long-run risks play a more important role to account for high equity premium than business cycle risks.

I study the link between capital markets and sources of macroeconomic risk. In chapter 1 I show that expected inflation risk is priced in the cross section of stock returns even after controlling for cash flow growth and volatility risks. Motivated by this evidence I study a long run risk model with a built-in inflation non-neutrality channel that allows me to decompose the real stochastic discount factor into news about current and expected cash flow growth, news about expected inflation and news about volatility. The model can successfully price a broad menu of assets and provides a setting for analyzing cross sectional variation in expected inflation risk premium. For industries like retail and durable goods inflation risk can account for nearly a third of the overall risk premium while the energy industry and a broad commodity index act like inflation hedges. Nominal bonds are exposed to expected inflation risk and have inflation premiums that increase with bond maturity. The price of expected inflation risk was very high during the 70's and 80's, but has come down a lot since being very close to zero over the past decade. On average, the expected inflation price of risk is negative, consistent with the view that periods of high inflation represent a "bad" state of the world and are associated with low economic growth and poor stock market performance. In chapter 2 I look at the way capital markets react to predetermined macroeconomic announcements. I document significantly higher excess returns on the US stock market on macro release dates as compared to days when no macroeconomic news hit the market. Almost the entire equity premium since 1997 is being realized on days when macroeconomic news are released. At high frequency, there is a pattern of returns increasing in the hours prior to the pre-determined announcement time, peaking around the time of the announcement and dropping thereafter.

U.S. MNEs are dominant producers in the economy, yet they invest considerably less and exhibit lower Tobin's q than domestic firms. Counterintuitively, the MNE investment premium mainly realizes as multinationalizing firms sharply reduce investment despite the productivity increase. The first chapter documents this novel fact and explains why MNEs invest less despite higher productivity as a consequence of multinationalization option exercise. Average U.S. public firms hold multinational investment opportunities as large as 40% of assets at the time of multinationalization. The model generates endogenous multinationalization by more productive firms and isolates the pure real option effect that explains MNE investment premium. Investment regressions ignoring commonly priced large-scale options such as multinationalization mistakenly suggests secular underinvestment for the most productive group of firms. Multinationalization is a common, large, and permanent corporate investment mechanism, and multinational status places one of the most informative observable for the optimal investment policy.

Domestic firms become considerably different in many aspects (e.g. size, profitability, and investment) as they transition to be multinational enterprises. The second chapter documents that multiple dimensional shifts of multinationalization dynamics spilling over to the aggregate realm as a large mass of U.S. firms multinationalized in the late-1990s. The mass-multinationalization hypothesis jointly explains recently raised pressing puzzles of aggregate movements of investment, q, and profitability while remaining consistent with the documented secular agglomeration patterns. Evidence also shows that multinationalization may further explain the dynamics of intangible, labor, and capital shares of production, increasing concentration, and market power. Mass-multinationalization of the late-1990s transmitted large firm-level dynamics of multinationalization events to the aggregate-level. The mass-multinationalization looks to be triggered by a substantial improvement in the incentive to integrate foreign demand chain for the U.S. products and services, rather than foreign supply chains which grew during the mid-2000s. The mass-multinationalization hypothesis is a firm-level and action-based mechanism that rationalizes the joint dynamics of secular movements without alternative explanations suggested in the literature.

I provide new evidence on the properties of the temporal structure of risk, which answers whether more distant claims to macroeconomic growth are more or less risky than near-term claims. In the first chapter, I use replication and no-arbitrage to estimate within-firm variation in equity expected returns across horizons. I demonstrate that a low dimensional set of returns and state variables, all characteristics of liquid, exchange-traded equity securities, provide a close replication of claims to firm capital gains at different horizons. Calculating returns from the no-arbitrage prices of these claims, I show that the term structure of risk premia is unconditionally upward-sloping for commonly used test assets like the market and book-to-market sorted portfolios. In joint work in the second chapter, we use traded equity dividend strips from U.S., Europe, and Japan from 2004-2017 to study the slope of the term structure of equity dividend risk premia. In the data, our robust finding is that the term structure of dividend risk premia (growth rates) is positively (negatively) sloped in expansions and negatively (positively) sloped in recessions. We develop a consumption-based regime switching model which matches these robust data-features and the historical probabilities of recession and expansion regimes. The unconditional population term structure of dividend risk premia in the regime-switching model, as in standard asset pricing models (habits and long-run risks), is increasing with maturity. In sum, our analysis shows that the empirical evidence in dividend strips is consistent with a positively sloped term structure of dividend risk-premia as implied by standard asset pricing models.

This dissertation studies the relation between technological innovation and asset prices. It explains the heterogeneity in the cross-sectional firm returns from the perspective of the technological race, in which firms with lagging technologies innovate to displace firms with leading technologies. In addition, it studies the resource reallocation from highly innovative firms towards less innovative firms, which is triggered by aggregate uncertainty spikes, and its economic growth implication. It proposes a novel link between technological growth and aggregate economic uncertainty.

The first chapter studies the cross-section of returns from the perspective of firms with differentially advanced technologies. Firms with leading technologies have some market power and enjoy monopolistic rents. Firms with lagging technologies, however, have to sell their products in more competitive markets. Lagging firms innovate to displace leaders in a technological race. I develop a general equilibrium model in which (1) technological leaders have market power and enjoy monopolistic rents, while followers generate no rents, and (2) each period, leaders, followers, and entrants innovate to take or keep the leading positions in the next period. Leading technologies are risky, since market power allows leaders to raise rents in good times and thus their monopoly profits are procyclical. Firms with high exposure to the risk of leading technologies (LTR) have high risk premia. While both current leaders and current followers can be the future leaders, the returns on current followers are more exposed to the future LTR and thus have higher premia, due to the potential large price jump from becoming a new leader. Empirically, I construct the factor that captures LTR. I find that leading technology is risky, and that the LTR price of risk is 7 percent. The followers that actively innovate have high exposure to the future LTR and high risk premia, supporting my model.

The second chapter, co-authored with Ravi Bansal, Mariano Max Croce and Samuel Rosen, shows the existence of a significant link between aggregate uncertainty and reallocation of resources away from R\&D-intensive capital, focusing on both micro and aggregate U.S. data. This link is important because a decrease in the aggregate share of R\&D-oriented capital forecasts lower medium-term growth. In a multi-sector production economy in which (i) growth is endogenously supported by risky R\&D investments, and (ii) the representative agent is volatility-risk averse and has access to other safer technologies that do not support growth, uncertainty shocks have a first-order negative impact on medium-term growth and welfare.