Browsing by Author "Ilut, Cosmin L"

This dissertation consists of three essays on asymmetric correlations in financial markets. In the first essay, I have two main contributions. First, I show that dividend growth rates have symmetric correlations. Second, I show that asymmetric correlations are different than correlations being counter-cyclical. The correlation asymmetry I study in this dissertation should not be confused with correlations being counter-cyclical, i.e. being higher during recessions than during booms. I show that while counter-cyclical correlations can simply be explained by counter-cyclical aggregate market volatility, the correlation asymmetry with respect to joint upside and downside movements of returns are not just due to the heightened market volatility during those times.

In the second essay I present a model in order to explain the correlation asymmetry observed in the data. This is the first paper to offer an explanation for observed correlation asymmetry. I formalize the explanation using an equilibrium model. The model is useful to understand both the cross-section and time-series of correlation asymmetry. By the means of my model, we can answer questions about why some stocks have higher correlation asymmetry, and why the correlation asymmetry was higher during 1990s? In the model asset prices respond the realization of dividends and news about the future. However, price responses to news are asymmetric and this asymmetry is endogenous. Price responses are endogenously stronger conditional on bad news than conditional on good news. This asymmetry also generates the observed correlation asymmetry. The price responses are asymmetric due to the ambiguity about the news quality. Information about the quality of the signal is incomplete in the sense that the exact precision of the signal is unknown; it is only known to be in an interval, which makes the representative agent treat news as ambiguous. To model ambiguity aversion, I use Gilboa and Schmeidler (1989)'s max-min expected utility representation. The agent has a set of beliefs about the quality of signals, and the ambiguity-averse agent behaves as if she maximizes expected utility under a worst-case scenario. This incomplete information about the news quality, together with ambiguity-averse agents, generates an asymmetric response to news. Endogenous worst-case scenarios differ depending on the realization of news. When observing ``bad" news, the worst-case scenario is that the news is reliable and the prices of trees decrease strongly. On the other hand, when ``good news" is observed, under the worst-case scenario the news is evaluated as less reliable, and thus the price increases are mild. Therefore, price responses are stronger conditional on a negative signal and this asymmetry creates a higher correlation conditional on a negative signal than conditional on a positive signal. I also show that the results are robust to the smooth ambiguity aversion representation.

Motivated by the model, I uncover a new empirical regularity that is unknown in the literature. I show that correlation asymmetry is related to idiosyncratic volatility: the higher the idiosyncratic volatility, the higher the correlation asymmetry. This novel empirical finding is also useful to understand the time-series and cross-sectional variation in correlation asymmetry. Stocks with smaller market capitalizations have greater correlation asymmetry compared to stocks with higher market capitalization. However, an explanation for this finding has been lacking. According to the explanation offered in this paper, smaller size stocks have greater correlation asymmetry compared to bigger size stocks because small size stocks tend to have higher idiosyncratic volatilities compared to bigger size stocks. In the time-series, correlation asymmetry shows quite significant variation as well. The average correlation asymmetry is especially high for the 1990s and decreases significantly at the beginning of the 2000s. This pattern in times-series can also be explained in terms of the time-series behavior of idiosyncratic volatilities. Several papers including Brandt et al. (2010), document higher idiosyncratic volatilities during 1990s while the aggregate volatility stays fairly stable. Basically, the high idiosyncratic volatilities during the 1990s also caused greater correlation asymmetry.

In the third essay, I study the correlation of returns in government bond markets. Similar to the findings in equity markets, I show that there is some evidence for asymmetric correlations in government bond markets. First, I show that the maturity structure matters for correlation asymmetry in bonds markets: Unlike long-maturity bonds, shorter-maturity bonds tend to have asymmetric correlations. Second, I show that the correlation asymmetry observed in European bond markets disappears with the formation of a common currency area. Lastly, I study the correlation between equity and bond returns in different countries. For long-maturity bonds, correlations with the domestic equity returns are asymmetric for half of the countries in the sample, including the U.S. These findings show that results on asymmetric correlations from equity markets can generalize, at least to some extent, to other financial markets.

This dissertation consists of my essays in macroeconomics. In the first essay, I develop a new general equilibrium model to explain several facts about aggregate inventory that are challenging to existing inventory models. This work highlights the importance of taking into account consumers' search behavior in understanding aggregate inventory dynamics. In the second essay, I adapt a Markov-switching vector autoregression (MS-VAR) to uncover detailed asymmetries embedded in inventory dynamics. This work further demonstrates the shortcomings of existing inventory models and points to new directions in improving inventory models.

This dissertation studies the interaction between ambiguity aversion and externalities in macroeconomic models. It considers this interaction in three different settings each developed in chapters 2, 3, and 4. Chapter 2 studies optimal portfolio choice where any given investor values returns relative to other investors' while facing ambiguity with respect to how returns are distributed. In this context, ambiguity introduces multiple equilibria, a subset of which seems, from an ambiguity neutral standpoint, as optimistic behavior while another subset appears to come from investors holding pessimistic beliefs. The model predicts that higher ambiguity relates to potentially higher degrees of over-pricing as well as under-pricing. Evidence from the pricing of recently public stocks is consistent with these predictions. Chapter 3 considers optimal macroprudential policy in an endowment economy with occasionally binding collateral constraints where households and the social planner face ambiguity with respect to the endowment process. In this setup, the decentralized equilibrium may differ from the social planner's both because of the pecuniary externalities associated with the collateral constraint and because of the paternalistic imposition of the planner's beliefs. The paternalism channel can amplify, attenuate, and even reverse welfare gains from policy intervention. Chapter 4 presents a static general equilibrium model with demand externalities and dispersed information where ambiguity-averse firms lack confidence in the joint distribution of their information. This lack of confidence, together with positive demand externalities, induces an asymmetric treatment of information which leads firms to respond more aggressively to bad news than to good news. This results in a downward-shifted and concave hiring rules which leads to lower aggregate employment growth that is more dispersed and more left-skewed in the cross-section. Empirical evidence shows a relation between moments of employment growth and ambiguity that are consistent with model predictions.