Asset Pricing

Members of the NBER's Asset Pricing Program met April 12 in Chicago. Research Associates Janice C. Eberly and Konstantin Milbradt, both of Northwestern University, organized the meeting. These researchers' papers were presented and discussed:

Ian Dew-Becker, Northwestern University and NBER, and Stefano Giglio, and Bryan T. Kelly, Yale University and NBER

Hedging Macroeconomic and Financial Volatility and Uncertainty

Dew-Becker, Giglio, and Kelly study the pricing of shocks to uncertainty and volatility using a novel and wide-ranging data set of options contracts directly related to the state of the macroeconomy and financial markets. If uncertainty shocks are viewed as bad by investors -- in the sense of being associated with high marginal utility -- portfolios that hedge them should earn negative premia. Empirically, however, contracts that provide protection against shocks to macroeconomic uncertainty have historically earned statistically and economically significantly positive excess returns. Instead, portfolios exposed to the realization (as opposed to the expectation) of large shocks to fundamentals have historically earned large and negative risk premia. The results imply that it is large realizations of shocks to fundamentals, not forward-looking uncertainty shocks, that drive investors' marginal utility, in turn, these implications dictate the role of volatility in macroeconomic models and indicate which shocks policymakers should aim to counteract.

Lubos Pastor and Pietro Veronesi, University of Chicago and NBER

Inequality Aversion, Populism, and the Backlash against Globalization (NBER Working Paper No. 24900)

Motivated by the recent rise of populism in western democracies, Pastor and Veronesi develop a model in which a populist backlash emerges endogenously in a growing economy. In the model, voters dislike inequality, especially the high consumption of "elites." Economic growth exacerbates inequality due to heterogeneity in risk aversion. In response to rising inequality, rich-country voters optimally elect a populist promising to end globalization. Countries with more inequality, higher financial development, and current account deficits are more vulnerable to populism, both in the model and in the data. Evidence on who voted for Brexit and Trump in 2016 also supports the model.

Robin Greenwood, Harvard University and NBER, and Annette Vissing-Jorgensen, University of California, Berkeley and NBER

The Impact of Pensions and Insurance on Global Yield Curves

Greenwood and Vissing-Jorgensen document a strong effect of pension and insurance company (P&I) assets on the long end of the yield curve. Using data from 26 countries, the yield spread between 30-year and 10-year government bond yields is negatively related to the ratio of pension assets (in funded and private pension and life insurance arrangements) to GDP, suggesting that preferred-habitat demand by the P&I sector for long-dated assets drives the long end of the yield curve. The researchers draw on changes in regulations in several European countries between 2008 and 2013 to provide well-identified evidence on the effect of the P&I sector on yields and to show that P&I demand is in part driven by hedging linked to the regulatory discount curve. When regulators reduce the dependence of the regulatory discount curve on a particular security, P&I demand for the security falls and its yield increases. These effects extend beyond long government bonds. The results suggest that pension discount rules can have a destabilizing impact on bond markets that reverses once rules are changed.

Grace Xing Hu, University of Hong Kong; and Jun Pan, Jiang Wang, and Haoxiang Zhu, MIT and NBER

Premium for Heightened Uncertainty: Solving the FOMC Puzzle

Lucca and Moench (2015) document that prior to the announcement from FOMC meetings, the stock market yields substantial returns without major increase in conventional measures of risk. This presents a "puzzle" to the simple risk-return connection in most (static) asset pricing models. Hu, Pan, Wang, and Zhu hypothesize that the arrival of macroeconomic news, with FOMC announcements at the top of the list, brings heightened uncertainty to the market, as investors cautiously await and assess the outcome. While this heightened uncertainty may not be accurately captured by conventional risk measures, its dissolution occurs during a short time window, mostly prior to the announcement, bringing a significant price appreciation. This hypothesis leads to two testable implications: First, similar return patterns for other pre-scheduled macroeconomic announcements should be observed. Second, to the extent that other proxies for heightened uncertainty can be found, abnormal returns accompanying its dissolution should also be observed. Indeed, the researchers find large pre-announcement returns prior to the releases of Nonfarm Payroll, GDP and ISM index. Using CBOE VIX index as a primitive gauge for market uncertainty, disproportionately large returns on days following large spike-ups in VIX are found. Akin to the FOMC result, such heightened-uncertainty days occur on average only eight times per year, but account for more than 30% of the average annual return on the S&P 500 index. Inspired by the VIX result, the researchers search for direct evidence of heightened uncertainty using VIX as a proxy and find a gradual but significant build-up in VIX over a window of up to six business days prior to the FOMC announcements.

Robert Novy-Marx, University of Rochester and NBER, and Mihail Z. Velikov, Federal Reserve Bank of Richmond

Betting Against Betting Against Beta

Frazzini and Pedersen's (2014) Betting Against Beta (BAB) factor is based on the same basic idea as Black's (1972) beta-arbitrage, but its astonishing performance has generated academic interest and made it highly influential with practitioners. Novy-Marx and Velikov show that this performance is driven by non-standard procedures used in its construction that effectively, but non-transparently, equal weight stock returns. For each dollar invested in BAB, the strategy commits on average $1.05 to stocks in the bottom 1% of total market capitalization. BAB earns positive returns after accounting for transaction costs, but earns these by tilting toward profitability and investment, exposures for which it is fairly compensated. Predictable biases resulting from the paper's non-standard beta estimation procedure drive results presented as evidence supporting its underlying theory.

Sung Je Byun, Federal Reserve Bank of Dallas, and Lawrence Schmidt, MIT

Real Risk or Paper Risk? Mis-measured Factors, Granular Measurement Errors, and Empirical Asset Pricing Tests

Given that the size distribution of publicly traded firms has fat tails, large idiosyncratic returns on large stocks can have nontrivial effects on the returns of value-weighted portfolios. Byun and Schmidt study effects of "granular measurement errors" -- which are present when the law of large numbers fails and idiosyncratic returns are not fully diversified away -- on standard empirical asset pricing tests. The researchers construct an empirical proxy for the granular measurement error and demonstrate that it contributes substantially to the observed volatility of the CRSP value-weighted index and other market proxies. Unpriced granular measurement errors lead to downward-biased estimates of the intertemporal risk-return relationship, generate biased estimates of systematic risk exposures in cross-sectional asset pricing tests. After making simple corrections to eliminate the effects of granular measurement errors, the researchers find much stronger evidence of an intertemporal risk-return relationship for the market index. In the cross section, betas for most portfolios -- especially portfolios of small stocks -- are severely biased downwards. After correcting estimated betas for the granular residual, the size anomaly disappears, and the researchers find evidence of an expected return-beta relationship consistent with basic CAPM/APT theory. Finally, instrumental variables estimates are used to provide direct evidence that the granular residual is less informative about current and future real activity, suggesting an economic rationale for it having a lower or even zero risk price.

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