Asset Pricing Program Meeting

April 19, 2013
Hui Chen and Andrew Lo, MIT, Organizers

Bruce Carlin and Francis Longstaff, University of California at Los Angeles and NBER, and Kyle Matoba, University of California at Los Angeles

Disagreement and Asset Prices (NBER Working Paper No. 18619)

How do differences of opinion affect asset prices? Do investors earn a risk premium when disagreement arises in the market? Despite their fundamental importance, these questions are among the most controversial issues in finance. Carlin, Longstaff, and Matoba use a novel data set that allows them to directly measure the level of disagreement among Wall Street mortgage dealers about prepayment speeds. They examine how disagreement evolves over time and study its effects on expected returns, return volatility, and trading volume in the mortgage backed security market. They find that increased disagreement is associated with higher expected returns, higher return volatility, and larger trading volume. These results imply that there is a positive risk premium for disagreement in asset prices. The authors also show that volatility in and of itself does not lead to higher trading volume. Rather, it is only when disagreement arises in the market that higher uncertainty is associated with more trading. Finally, they are able to distinguish empirically between two competing hypotheses regarding how information in markets gets incorporated into asset prices. They find that sophisticated investors appear to update their beliefs through a rational expectations mechanism when disagreement arises.

Suleyman Basak and Anna Pavlova, London Business School

A Model of Financialization of Commodities

A sharp increase in the popularity of commodity investing in the past decade has triggered an unprecedented inflow of institutional funds into commodity futures markets. Such financialization of commodities coincided with significant booms and busts in commodity markets, raising concerns of policymakers. Basak and Pavlova explore the effects of financialization in a model that features institutional investors alongside traditional futures markets participants. The institutional investors care about their performance relative to a commodity index. The authors find that if a commodity future is included in the index, then supply and demand shocks specific to that commodity spill over to all other commodity futures markets. In contrast, supply and demand shocks to a non-index commodity affect only that commodity market. Moreover, prices and volatilities of all commodity futures go up, but more so for the index futures than for non-index ones. Furthermore, financialization—the presence of institutional investors—leads to an increase in correlations among commodity futures as well as between equities and commodities. Consistent with the empirical evidence, the increases in the correlations between index commodities exceed those for non-index commodities. The authors explicitly model demand shocks, which allows them to disentangle the effects of financialization from the effects of demand and supply (fundamentals). They perform a simple calibration and find that financialization accounts for 11 to 17 percent of commodity futures prices; the rest is attributable to fundamentals.

Nicolae Garleanu, University of California at Berkeley and NBER; Stavros Panageas, University of Chicago and NBER; and Jianfeng Yu, University of Minnesota

Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion

Investors, firms, and intermediaries are located on a circle. Intermediaries facilitate risk sharing by allowing investors at their location to invest in firms at other locations. Access to markets is not frictionless, but involves participation costs that increase with distance. Asset prices, the extent of market integration, the extent of cross-location capital flows, and the resources devoted to the financial industry are jointly determined in equilibrium. Although investors at any location are identical to each other, Garleanu, Panageas, and Yu find that the financial sector may exhibit diversity, with some financial intermediaries in every location offering high-leverage, high-participation, and high-fee structures and some intermediaries offering unlevered, low-participation, and low-fee structures. The capital attracted by high-leverage strategies is vulnerable to even small changes in market access costs, leading to discontinuous price drops and portfolio-flow reversals. Moreover, an adverse shock to intermediaries at a subset of locations causes contagion, in the sense that it affects prices everywhere.

Martin Lettau, University of California at Berkeley and NBER; Matteo Maggiori, New York University; and Michael Weber, University of California at Berkeley

Conditional Risk Premia in Currency Markets and Other Asset Classes (NBER Working Paper No. 18844)

Lettau, Maggiori, and Weber note that the downside risk CAPM (DR-CAPM) can price the cross-section of currency returns. The market-beta differential between high- and low-interest-rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly explain the cross-section of equity, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.

Andrea Frazzini, AQR Capital Management; Ronen Israel, AQR Capital; and Tobias Moskowitz, University of Chicago and NBER

Trading Costs of Asset Pricing Anomalies

Using nearly a trillion dollars of live trading data from a large institutional money manager across 19 developed equity markets over the period 1998 to 2011, Frazzini, Israel, and Moskowitz measure the real-world transactions costs and price impact function facing an arbitrageur and apply them to size, value, momentum, and shortterm reversal strategies. They find that actual trading costs are less than a tenth as large as, and therefore the potential scale of these strategies is more than an order of magnitude larger than, previous studies suggest. Furthermore, strategies designed to reduce transactions costs can increase net returns and capacity substantially, without incurring significant style drift. Results vary across styles, with value and momentum being more scalable than size, and short-term reversals being the most constrained by trading costs. They conclude that the main anomalies to standard asset pricing models are robust, implementable, and sizeable.

Leonid Kogan, Massachusetts Institute of Technology and NBER; Dimitris Papanikolaou, Northwestern University and NBER; and Noah Stoffman, Indiana University

Technological Innovation: Winners and Losers (NBER Working Paper No. 18671)

Kogan, Papanikolaou, and Stoffman analyze the effect of innovation on asset prices in a tractable, general equilibrium framework with heterogeneous households and firms. Innovation has a heterogenous impact on households and firms. Technological improvements embodied in new capital benefit workers, while displacing existing firms and their shareholders. This displacement process is uneven: newer generations of shareholders benefit at the expense of existing cohorts; firms well positioned to take advantage of these opportunities benefit at the expense of firms unable to do so. Under standard preference parameters, the risk premium associated with innovation is negative. This model delivers several stylized facts about asset returns, consumption, and labor income. The authors derive and test new predictions of their framework using a direct measure of innovation. The model's predictions are supported by the data.

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