Asset Pricing

November 10, 2017
Leonid Kogan and Jun Pan, both of MIT, Organizers

Michael Gofman, the University of Rochester; Gill Segal, the University of North Carolina at Chapel Hill; and Youchang Wu, the University of Oregon

Production Networks and Stock Returns: The Role of Creative Destruction

Gofman, Segal, and Wu establish a novel return spread based on the distance between firms and final consumers in a production network. Firms with the longest distance to consumers earn an excess monthly return of 105 basis points relative to final goods producers. The researchers explain this spread quantitatively using a general equilibrium model with multiple layers of production. The driving force behind the spread is creative destruction, which reduces firms' exposure to productivity shocks. The spread is smaller for firms that belong to supply chains with lower competition. Overall, the researchers' results demonstrate a novel effect of creative destruction on firms' cost of capital.

Ricardo J Caballero and Alp Simsek, MIT and NBER

A Risk-centric Model of Demand Recessions and Macroprudential Policy (NBER Working Paper No. 23614)

A productive capacity generates output and risks, both of which need to be absorbed by economic agents. If they are unable to do so, output and risk gaps emerge. Risk gaps close quickly: A decline in the interest rate increases the Sharpe ratio of the risky assets and equilibrates the risk markets. If the interest rate is constrained from below (or the policy response is slow), the risk markets are instead equilibrated via a decline in asset prices. However, the drop in asset prices also drags down aggregate demand and generates a recession, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and growth. The fear of a recession with a downward asset price spiral also reduces the interest rate ("rstar") during the boom. In this context, belief disagreements can be highly destabilizing, as they induce investors to take speculative positions that make the economy effectively extrapolative: raising optimism during the boom and pessimism during the recession. Speculation exacerbates the dynamic feedbacks and motivates macroprudential policy. Optimists take too much risk from a social point of view since they do not internalize their positive effect on asset prices and aggregate demand during recessions. Macroprudential policy can improve outcomes (in a Pareto and a belief-neutral sense), and is procyclical as the negative aggregate demand effect of prudential tightening is more easily offset by interest rate policy during booms than during recessions.

Azi Ben-Rephael, Indiana University; Bruce I. Carlin, the University of California at Los Angeles and NBER; Zhi Da, the University of Notre Dame; and Ryan D. Israelsen, Michigan State University

Demand for Information and Asset Pricing (NBER Working Paper No. 23274)

Typically, academics rely on the supply of information that arrives to market (e.g., macroeconomic announcements, earnings reports, or news releases) to study how information affects asset prices. In this paper, Ben-Rephael, Carlin, Da, and Israelsen use measures of demand for information. They show that institutional demand is much more likely than information supply to be associated with a risk premium because it captures systematic information that spills over from other stocks and the macroeconomy. Consistent with this, the CAPM performs better when institutions demand information, and the positive effect of FOMC announcements on risk premia (Savor and Wilson, 2014) appears to be modulated by investor demand for information on individual stocks.

Antonio Falato, Federal Reserve Board; Ali Hortaçsu, the University of Chicago and NBER; and Dan Li and Chaehee Shin, Federal Reserve Board

Fire-Sale Spillovers in Debt Markets

Falato, Hortaçsu, Li and Shin assess fire-sale spillovers empirically using a new approach to measure network linkages across financial institutions and rich micro data for the universe of open-end fixed-income mutual funds. They find evidence that flows are interdependent across funds with asset class overlap, consistent with the hypothesis that one fund's redemptions may spill-over on to those of other funds by leading to distressed sales that adversely impact other funds' performance. The researchers use several strategies to identify the causal link between any given fund's flows and those of its peers, including a regression discontinuity (RD) design that exploits sharp changes in peer flows around Morningstar 5-star ratings. The source of identification of our RD approach is quasi-random variation in peer flows around the arbitrary performance cutoffs used by Morningstar to assign their 5-star ratings, which is plausibly unrelated to changes in common industry fundamentals. Consistent with a fire-sale mechanism, not just fund flows, but also fund performance and liquidity, as well as the pricing of corporate bonds sold by funds under peer pressure, are adversely affected. The researchers' approach yields simple measures of vulnerability of a fund family to system-wide flow pressures, which can be used for policy evaluation of alternative financial stability tools.

Carolin Pflueger, the University of British Columbia; Emil Siriwardane, Harvard University; and Adi Sunderam, Harvard University and NBER

Does Precautionary Savings Drive the Real Interest Rate? Evidence from the Stock Market

Pflueger, Siriwardane, and Sunderam document a strong and robust relationship between the one-year real rate and the valuation of high-volatility stocks, which they contend measures precautionary savings motives. The researchers' novel proxy for precautionary savings explains 41% of the variation in the real rate. In addition, the real rate forecasts returns on the low-minus-high volatility portfolio but has little relation to observable measures of the quantity of risk. These results suggest that precautionary savings motives, and thus the real rate, are driven by time-varying attitudes towards risk. The researchers' findings are difficult to rationalize in models with perfect risk sharing and highlight the role that imperfect diversification plays in determining interest rates. They also explore the implications of their findings for monetary policy, arguing that precautionary savings motives should be included in assessing the natural real rate.

Anna Cieslak, Duke University, and Annette Vissing-Jorgensen, the University of California at Berkeley and NBER

The Economics of the Fed Put

Cieslak and Vissing-Jorgensen study the impact of the stock market on the Federal Reserve's monetary policy. They analyze the economics behind the "Fed put," i.e., the tendency for low stock returns to predict accommodating monetary policy. They show that stock returns are a statistically more powerful predictor of Federal funds target changes than standard macroeconomic news releases. Using textual analysis of FOMC minutes and transcripts, the researchers then argue that stock returns cause Fed policy. FOMC participants are more likely to be concerned about the stock market after market declines and the frequency of negative stock market mentions in FOMC documents predicts target rate cuts. The focus on the stock market reflects Fed's concern about the consumption-wealth effect and about the impact of the stock market on investment, with less role for the stock market simply predicting (as opposed to driving) the economy. The researchers assess whether the Fed may be reacting too much to the stock market by (a) comparing the sensitivity to the stock market of the Fed's growth, unemployment and inflation forecasts with the stock-market sensitivity of private sector forecasts, and (b) estimating whether the stock market impacts target changes even after controlling for Fed expectations of economic activity and inflation.

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