Asset Pricing Program Meeting

April 29, 2011
Arvind Krishnamurthy and Annette Vissing-Jorgensen, Northwestern University, Organizers

Anna Cieslak, Northwestern University, and Pavol Povala, University of Lugano
Understanding Bond Risk Premia

Cieslak and Povala decompose long-term yields into a persistent component and maturity-related cycles to study the predictability of bond excess returns. Predictive regressions of one-year excess bond returns on a common factor constructed from the cycles give R2's up to 60 percent across maturities. The result holds true in different datasets, passes a range of out-of-sample tests, and is not sensitive to the inclusion of the monetary experiment (1979/83), or the recent crisis (2007/09). The authors identify a simple economic mechanism that underlies this robust feature of the data: cycles represent deviations from the long-run relationship between yields and the slow-moving component of expected inflation. This single observation extends to a number of insights. First, they show that a key element for return predictability is contained in the first principal component of yields: the level. Once they account for this information, there is little they can learn about term premiums from other principal components. Second, they interpret the standard predictive regression using forward rates as a constrained case of a more general return forecasting factor that could have been exploited by bond investors in real time. Third, using a dynamic term structure model, they quantify a nontrivial cross-sectional impact of that encompassing factor on yields that increases with the maturity of the bond. Finally, conditional on those findings, they revisit the additional predictive content of macroeconomic fundamentals for bond returns. By rendering most popular predictors insignificant, their forecasting factor aggregates a variety of macro-finance risks into a single quantity.

Matthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig, University of California at Los Angeles and NBER

Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle (NBER Working Paper No. 16358)

Fleckenstein, Longstaff, and Lustig show that the price of a Treasury bond and an inflation-swapped TIPS issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS-Treasury mispricing has exceeded $56 billion, representing nearly 8 percent of the total amount of TIPS outstanding. TIPS-Treasury mispricing is strongly related to supply factors such as Treasury debt issuance and the availability of collateral in the financial markets, and is correlated with other types of fixed-income arbitrages, These results pose a major puzzle to classical asset pricing theory. In addition, they raise the issue of why the Treasury issues TIPS, since in so doing it both gives up a valuable fiscal hedging option and leaves large amounts of money on the table.

Michael Johannes, Lars Lochstoer, and Yiqun Mou, Columbia University
Learning About Consumption Dynamics

Johannes, Lochstoer, and Mou study the asset pricing implications of Bayesian learning about the parameters, states, and models determining aggregate consumption dynamics. Their approach is empirical and focuses on the quantitative implications of learning in real-time using post World War II consumption data. They characterize this learning process and provide empirical evidence that revisions in beliefs stemming from parameter and model uncertainty are significantly related to realized aggregate equity returns. Further, they show that beliefs regarding the conditional moments of consumption growth are strongly time-varying and exhibit business cycle and/or long-run fluctuations. Much of the long-run behavior is unanticipated ex ante. The authors embed these subjective beliefs in a general equilibrium model and find that about half of the post World-War II observed equity market risk premium and much of the observed return predictability are due to unexpected revisions in beliefs about parameters and models governing consumption dynamics.

Xing Hu, Princeton University, and Jun Pan and Jiang Wang, MIT and NBER

Noise (NBER Working Paper No. 16468)

Hu, Pan, and Wang propose a broad measure of liquidity for the overall financial market by exploiting its connection with the amount of arbitrage capital in the market and the potential impact on price deviations in U.S. Treasuries. When arbitrage capital is abundant, they expect the arbitrage forces to smooth out the Treasury yield curve and to keep the dispersion low. During market crises, the shortage of arbitrage capital leaves the yields to move more freely relative to the curve, resulting in more "noise." As such, noise in the Treasury market can be informative and the authors expect this information about liquidity to reflect the broad market conditions because of the central importance of the Treasury market and its low intrinsic noise -- high liquidity and low credit risk. Indeed, they find that their "noise" measure captures episodes of liquidity crises of different origins and magnitudes and is also related to other known liquidity proxies. Moreover, using it as a priced risk factor helps to explain cross-sectional returns on hedge funds and currency-carry trades, both known to be sensitive to the general liquidity conditions of the market.

Jack Favilukis, London School of Economics, and Sydney C. Ludvigson and Stijn Van Nieuwerburgh, New York University and NBER

The Macroeconomic Effects of Housing Wealth, Housing Finance, and Limited Risk-Sharing in General Equilibrium (NBER Working Paper No. 15988)

Favilukis, Ludvigson, and Van Nieuwerburgh study the role of time-varying risk premiumsa as a channel for generating and propagating fluctuations in housing markets, aggregate quantities, and consumption and wealth heterogeneity. They study a two-sector general equilibrium model of housing and non-housing production where heterogeneous households face limited opportunities to insure against aggregate and idiosyncratic risks. The model generates large variability in the national house price-rent ratio, both because it fluctuates endogenously with the state of the economy and because it rises in response to a relaxation of credit constraints and decline in housing transaction costs (financial market liberalization). These factors, together with a rise in foreign ownership of U.S. debt calibrated to match the actual increase over the period 2000-2006, generate fluctuations in the model price-rent ratio that explain between 80 and 100 percent of the increase in the national price-rent observed in U.S. data over this period. The model also predicts a sharp decline in home prices starting in 2007, driven by the economic contraction and by a presumed reversal of the financial market liberalization. Fluctuations in the models price-rent ratio are driven by changing risk premiums, which fluctuate endogenously in response to cyclical shocks, the financial market liberalization, and its subsequent reversal. By contrast, they show that the inflow of foreign money into domestic bond markets plays a small role in driving home prices, despite its large depressing influence on interest rates. Finally, the model implies that pro-cyclical increases in equilibrium price-rent ratios reflect rational expectations of lower future housing returns, not higher future rents.

Harrison Hong, Princeton University and NBER, and David Sraer, Princeton University
Quiet Bubbles

Classic speculative bubbles are loud -- price is high and so are price volatility and share turnover. The credit bubble of 2003-2007 is quiet -- price is high but price volatility and share turnover are low. Hong and Sraer develop a model, based on investor disagreement and short-sales constraints, that explains why credit bubbles are quieter than equity ones. Since debt up-side pay-offs are bounded, debt is less sensitive to disagreement about underlying asset value than equity and hence has a smaller resale option and lower price volatility and turnover. Large debt mispricing requires, in contrast to equity, either greater leverage or investor optimism. An increase in optimism makes debt but not equity bubbles quieter. Even holding fixed average optimism, an increase in disagreement with enough leverage can lead to a large and quiet debt mispricing. The theory here provides a first attempt at a taxonomy of bubbles.

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