Asset Pricing

April 10
Nikolai Roussanov and Jules H. van Binsbergen, both of University of Pennsylvania, Organizers

William Fuchs and Brett Green, University of California, Berkeley, and Dimitris Papanikolaou, Northwestern University and NBER

Adverse Selection, Slow Moving Capital and Misallocation

Fuchs, Green, and Papanikolaou embed adverse selection into a dynamic, general equilibrium model with heterogeneous capital and study its implications for aggregate dynamics. The information friction leads to delays in capital reallocation and thus slow recoveries from shocks, even when these shocks do not affect the economy’s potential output. The researchers' model provides a micro-foundation for convex adjustment costs, and links the magnitude of these costs to the underlying economic environment. The model also predicts that the effective costs to reallocation increase with dispersion in productivity and decrease with the interest rate, the frequency of sectoral shocks and households consumption smoothing motives. When households are risk averse, delaying reallocation serves as a hedge against future shocks, which can lead to persistent misallocation.

Nicolae B. Gârleanu, University of California, Berkeley and NBER; Stavros Panageas, University of Chicago and NBER; and Jianfeng Yu, University of Minnesota

Impediments to Financial Trade: Theory and Measurement

Gârleanu, Panageas, and Yu propose a tractable model of an informationally inefficient market. The researchers show the equivalence between their model and a substantially simpler model whereby investors face distortive investment taxes depending both on their identity and the asset class. The authors use this equivalence to assess existing approaches to inferring whether individual investors have informational advantages. They also develop a methodology of inferring the magnitude of the frictions (implicit taxes) that impede financial trade. They illustrate the methodology by using data on cross-country portfolio holdings and returns to quantify these frictions, and locate the directions in which financial trade seems to be especially impeded. The researchers argue that their measure of frictions contains useful information for the sources of failure of frictionless models, and it helps in studying whether certain factors (such as the size of the financial sector) are associated with lower financial frictions.

Anna Cieslak, Northwestern University; Adair Morse, University of California, Berkeley and NBER; and Annette Vissing-Jorgensen, University of California at Berkeley and NBER

Stock Returns over the FOMC Cycle

Cieslak, Morse, and Vissing-Jorgensen document that since 1994 the U.S. equity premium follows an alternating weekly pattern measured in FOMC cycle time, i.e. in time since the last Federal Open Market Committee meeting. The equity premium is earned entirely in weeks 0, 2, 4 and 6 in FOMC cycle time (with week 0 starting the day before a scheduled FOMC announcement day). The researchers show that this pattern is likely to reflect a risk premium for news (about monetary policy or the macro economy) coming from the Federal Reserve: (1) The FOMC calendar is quite irregular and changes across sub-periods over which their finding is robust. (2) Even weeks in FOMC cycle time do not line up with other macro releases. (3) Volatility in the fed funds futures market and the federal funds market (but not to the same extent in other markets) peaks during even weeks in FOMC cycle time. (4) Information processing/decision making within the Fed tends to happen bi-weekly in FOMC cycle time: Before 1994, when changes to the Fed funds target in between meetings were common, they disproportionately took place during even weeks in FOMC cycle time. In addition, after 2001 Board of Governors discount rate meetings (at which the board aggregates policy requests from regional federal reserve banks and receives staff briefings) tend to take place bi-weekly in FOMC cycle time. As for how the information gets from the Federal Reserve to the market, the authors rule out the Federal Reserve signaling policy via open market operations post-1994. Furthermore, the high return weeks do not systematically line up with official information releases from the Federal Reserve or with the frequency of speeches by Fed officials. The researchers end with a discussion of quiet policy communications and unintended information flows.

Martin Lettau, University of California, Berkeley and NBER; Sydney C. Ludvigson, New York University and NBER; and Sai Ma, New York University

Capital Share Risk and Shareholder Heterogeneity in U.S. Stock Pricing (NBER Working Paper No. 20744)

Value and momentum strategies earn persistently large return premia yet are negatively correlated. Why? Lettau, Ludvigson, and Ma show that a quantitatively large fraction of the negative correlation is explained by strong opposite signed exposure of value and momentum portfolios to a single aggregate risk factor based on low frequency √°uctuations in the capital share. Moreover, this negatively correlated component is priced. Models with capital share risk explain up to 85% of the variation in average returns on size-book/market portfolios and up to 95% of momentum returns and the pricing errors on both sets of portfolios are lower than those of the Fama-French three- and four-factor models, the intermediary SDF model of Adrian, Etula, and Muir (2014), and models based on low frequency exposure to aggregate consumption risk. None of the betas for these factors survive in a horse race where a long-horizon capital share beta is included. The researchers demonstrate that opposite signed exposure of value and momentum to capital share risk coincides with opposite signed exposure of these strategies to the income shares of stockholders in the top 10 versus bottom 90 percent of the stock wealth distribution. These findings can be explained if investors located in different percentiles of the wealth distribution exhibit a central tendency to pursue different investment strategies.

Peter Feldhütter and Stephen Schaefer, London Business School

The Credit Spread Puzzle in the Merton Model - Myth or Reality?

Feldhütter and Schaefer test the Merton model of credit risk using data on individual firms for the period 1997-2012. They find that the model matches the average level of investment grade spreads and furthermore captures the time series variation of the BBB-AAA spread well with a correlation between 83% and 94% depending on bond maturity. A crucial ingredient to the success of the model is that the researchers use default rates for a long period of around 90 years to calibrate the model. In simulations the authors show that such a long history of default rates is essential to reliably pin down expected default probabilities; using default rates from short periods will often lead to the conclusion that spreads in the Merton model are too low even if the Merton model is the true model. Finally, the researchers show that using data on individual firms - rather than a "representative firm" - is important for matching the slope of the term structure of credit spreads.

Andrea Buffa, Boston University; Dimitri Vayanos, London School of Economics and NBER; and Paul Woolley, London School of Economics

Asset Management Contracts and Equilibrium Prices (NBER Working Paper No. 20480)

Buffa, Vayanos, and Woolley study the joint determination of fund managers' contracts and equilibrium asset prices. Because of agency frictions, investors make managers' fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts.

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