Essays in Financial Economics
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.
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