Essays in Financial Economics
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.
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