Asset Pricing Program Meeting
October 26, 2012
David Lucca and Emanuel Moench, Federal Reserve Bank of New York
Since the Federal Open Market Committee (FOMC) began announcing its monetary policy decisions in 1994, U.S. stocks have experienced large excess returns in the 24 hours preceding these announcements. The abnormal returns account for more than 80 pecent of the U.S. equity premium over the past 17 years. Other major international equity indexes experienced similar abnormal returns before FOMC announcements. In contrast, no such return pattern is detectable on U.S. fixed income assets, or on the exchange value of the dollar. Lucca and Moench discuss a few possible explanations for the pre-FOMC announcement drift for equities, none of which appears to be fully consistent with the empirical evidence.
Lubos Pastor and Pietro Veronesi, University of Chicago and NBER
Pastor and Veronesi develop a general equilibrium model of government policy choice in which stock prices respond to political news. The model implies that political uncertainty commands a risk premium whose magnitude is larger in weaker economic conditions. Political uncertainty reduces the value of the implicit put protection that the government provides to the market. It also makes stocks more volatile and more correlated, especially when the economy is weak. The authors find empirical evidence consistent with these predictions.
Jack Favilukis, London School of Economics, and Xiaoji Lin, Ohio State University
In standard models,wages are too volatile and returns are too smooth. Favilukis and Lin make wages sticky through infrequent resetting, resulting in both 1) smoother wages and 2) volatile returns. Furthermore, their model produces other puzzling features of financial data: 3) high Sharpe Ratios, 4) low and smooth interest rates, 5) time-varying equity volatility and premium, and 6) a value premium. In standard models, highly pro-cyclical and volatile wages are a hedge. The residual (profit) becomes unrealistically smooth, as do returns. Smoother wages act like operating leverage, making profits more risky. Bad times and unproductive firms are especially risky because committed wage payments are high relative to output.
Tobias Adrian, Federal Reserve Bank of New York; Tyler Muir, Northwestern University; and Erkko Etula, Goldman, Sachs & Co.
Financial intermediaries trade frequently in many markets using sophisticated models. Their marginal value of wealth thus should provide a more informative stochastic discount factor (SDF) than that of a representative consumer. Guided by theory, Adrian, Muir, and Etula use shocks to the leverage of securities broker-dealers to construct an intermediary SDF. Intuitively, deteriorating funding conditions are associated with deleveraging and high marginal value of wealth. Their single - factor model prices size, book-to-market, momentum, and bond portfolios with an R2 of 77 percent and an average annual pricing error of 1 percent - performing as well as standard multi-factor benchmarks designed to price these assets.
Snehal Banerjee, Northwestern University, and Jeremy Graveline, University of Minnesota
When market frictions restrict the aggregate quantity of long and short positions in a security, the security becomes "scarce," and its price is distorted relative to its frictionless value. Banerjee and Graveline show that even simple derivatives, exposed to the same sources of risk as the underlying security, are no longer redundant. Moreover, in equilibrium, trade in derivatives may actually affect the price of the underlying. The authors characterize equilibrium prices and trading volume in the underlying security and its derivative, and show that improving ease of trade in the derivative can reduce price distortions in the underlying security.
Dong Lou and Christopher Polk, London School of Economics
Lou and Polk propose a novel measure of the amount of arbitrage capital allocated to the momentum strategy to test whether arbitrageurs can have a destabilizing effect in the stock market. Their measure, which they dub co-momentum, aims to capture the extent to which momentum trades by arbitrageurs become crowded. Specifically, they define co-momentum as the high frequency abnormal return correlation among stocks on which a typical momentum strategy would speculate. They show that during periods of low co-momentum, momentum strategies are profitable and stabilizing, reflecting an under-reaction phenomenon that arbitrageurs correct. In contrast, during periods of high co-momentum, these strategies become unprofitable and tend to crash, reflecting prior over-reaction caused by the momentum crowd pushing prices away from fundamentals. Moreover, both firm-level and international versions of co-momentum forecast returns in a manner consistent with this interpretation.