Francis A. Longstaff, UC, Los Angeles and NBER, and Jiang Wang, MIT and NBER
Asset Pricing and the Credit Market
Longstaff and Wang study the central role of the credit market in shaping the behavior of financial markets and asset prices. They show that the credit market facilitates optimal risk sharing by allowing less-risk-averse agents to bear more risk and take on levered positions in risky assets, effectively buying call options on the economy from more-risk-averse agents. Moreover, the equilibrium amount of credit changes through the economy cycles and modifies the amount of risk sharing, which in turn influences the behavior of asset prices such as expected stock returns, stock return volatility, and the term structure of interest rates.
Dimitros Vayanos, London School of Economics and NBER, and Paul Wooley, London School of Economics
An Institutional Theory of Momentum and Reversal
Vayanos and Woolley propose a rational theory of momentum and reversal based on delegated portfolio management. A competitive investor can invest through an index fund or an active fund run by a manager with unknown ability. Following a negative cash flow shock to assets held by the active fund, the investor updates negatively about the managers ability and migrates to the index fund. While prices of assets held by the active fund drop in anticipation of the investors outflows, the drop is expected to continue, leading to momentum. Because outflows push prices below fundamental values, expected returns eventually rise, leading to reversal. Fund flows generate co-movement and lead-lag effects, with predictability being stronger for assets with high idiosyncratic risk. The authors derive explicit solutions for asset prices, within a continuous-time normal-linear equilibrium.
Bernard Dumas, University of Lausanne and NBER, and Andrew Layasoff, Boston University
Incomplete-Market Equilibria Solved Recursively on an Event Tree
Dumas and Lyasoff develop a method that allows for computing incomplete-market equilibriums routinely for Markovian equilibriums (when they exist). The main difficulty to be overcome arises from the set of state variables. There are, of course, exogenous state variables driving the economy but, in an incomplete market, there are also endogenous state variables, which introduce path dependence. The researchers write on an event tree the system of all first-order conditions of all times and states and solve recursively for state prices, which are dual variables. They illustrate this "dual" method and show its many practical advantages by means of several examples.
Nicolae Garleanu, UC, Berkeley and NBER, LEONID KOGAN, MIT and NBER, and Stavros Panageas, University of Chicago
The Demographic of Innovation and Asset Returns
Garleanu and his co-authors study asset-pricing implications of innovation in a general-equilibrium overlapping generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Thus, innovation creates a risk factor, which they call the displacement risk. Displacement risk is a systematic risk factor attributable to the lack of inter-generational risk sharing. The researchers show that the standard aggregate consumption-based asset-pricing model must be modified to account for inter-cohort consumption differences generated by the displacement-risk factor. This new risk factor helps explain several empirical patterns in asset returns, including the existence of the growth-value factor in returns and the value premium, and the high equity premium. The calibration results suggest that the proposed mechanism is quantitatively consistent with the data.