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Financing asset growth
(2012)
We document the existence of a debt anomaly that is in addition to the asset growth anomaly: for a given asset growth rate, firms that issue more debt, as well as firms that retire more debt, have lower stock returns in the 12 months starting 6 months after the calendar year of asset growth. Exploring the reasons for debt issuance, we find that managers of firms for which analyst expectations are more over-optimistic, which suffer from declining investment profitability, and whose earnings-price ratios are relatively high are inclined to rely more heavily on debt financing. On the other hand, firms that retire more debt for a given asset growth rate tend to have improving profitability but to be over-priced. We also find that the financing decision is influenced by the prior debt ratio, the asset growth rate, profitability, and CEO pay sensitivity. We interpret our results in terms of managerial incentives, signaling, and market timing.
We characterize optimal redistribution in a dynastic family model with human capital. We show how a government can improve the trade-off between equality and incentives by changing the amount of observable human capital. We provide an intuitive decomposition for the wedge between human-capital investment in the laissez faire and the social optimum. This wedge differs from the wedge for bequests because human capital carries risk: its returns depend on the non-diversi
able risk of children's ability. Thus, human capital investment is encouraged more than bequests in the social optimum if human capital is a bad hedge for consumption risk.
Money is more than memory
(2014)
Impersonal exchange is the hallmark of an advanced society. One key institution for impersonal exchange is money, which economic theory considers just a primitive arrangement for monitoring past conduct in society. If so, then a public record of past actions — or memory — supersedes the function performed by money. This intriguing theoretical postulate remains untested. In an experiment, we show that the suggested functional equality between money and memory does not translate into an empirical equivalence. Monetary systems perform a richer set of functions than just revealing past behaviors, which proves to be crucial in promoting large-scale cooperation.
Emotions-at-risk: an experimental investigation into emotions, option prices and risk perception
(2014)
This paper experimentally investigates how emotions are associated with option prices and risk perception. Using a binary lottery, we find evidence that the emotion ‘surprise’ plays a significant role in the negative correlation between lottery returns and estimates of the price of a put option. Our findings shed new light on various existing theories on emotions and affect. We find gratitude, admiration, and joy to be positively associated with risk perception, although the affect heuristic predicts a negative association. In contrast with the predictions of the appraisal tendency framework (ATF), we document a negative correlation between option price and surprise for lottery winners. Finally, the results show that the option price is not associated with risk perception as commonly used in psychology.
This chapter analyzes the risk and return characteristics of investments in artists from the Middle East and Northern Africa (MENA) region over the sample period 2000 to 2012. With hedonic regression modeling we create an annual index that is based on 3,544 paintings created by 663 MENA artists. Our empirical results prove that investing in such a hypothetical index provides strong financial returns. While the results show an exponential growth in sales since 2006, the geometric annual return of the MENA art index is a stable13.9 percent over the whole period. We conclude that investing in MENA paintings would have been profitable but also note that we examined the performance of an emerging art market that has only seen an upward trend without any correction, yet.
The record-breaking prices observed in the art market over the last three years raise the question of whether we are experiencing a speculative bubble. Given the difficulty to determine the fundamental value of artworks, we apply a right-tailed unit root test with forward recursive regressions (SADF test) to detect explosive behaviors directly in the time series of four different art market segments (“Impressionist and Modern”, “Post-war and Contemporary”, “American”, and “Latin American”) for the period from 1970 to 2013. We identify two historical speculative bubbles and find an explosive movement in today’s “Post-war and Contemporary” and “American” fine art market segments.
This paper investigates the impact of news media sentiment on financial market returns and volatility in the long-term. We hypothesize that the way the media formulate and present news to the public produces different perceptions and, thus, incurs different investor behavior. To analyze such framing effects we distinguish between optimistic and pessimistic news frames. We construct a monthly media sentiment indicator by taking the ratio of the number of newspaper articles that contain predetermined negative words to the number of newspaper articles that contain predetermined positive words in the headline and/or the lead paragraph. Our results indicate that pessimistic news media sentiment is positively related to global market volatility and negatively related to global market returns 12 to 24 months in advance. We show that our media sentiment indicator reflects very well the financial market crises and pricing bubbles over the past 20 years.
Since the 2008 financial crisis, in which the Reserve Primary Fund “broke the buck,” money market funds (MMFs) have been the subject of ongoing policy debate. Many commentators view MMFs as a key contributor to the crisis because widespread redemption demands during the days following the Lehman bankruptcy contributed to a freeze in the credit markets. In response, MMFs were deemed a component of the nefarious shadow banking industry and targeted for regulatory reform. The Securities and Exchange Commission’s (SEC) misguided 2014 reforms responded by potentially exacerbating MMF fragility while potentially crippling large segments of the MMF industry.
Determining the appropriate approach to MMF reform has been difficult. Banks regulators supported requiring MMFs to trade at a floating net asset value (NAV) rather than a stable $1 share price. By definition, a floating NAV prevents MMFs from breaking the buck but is unlikely to eliminate the risk of large redemptions in a time of crisis. Other reform proposals have similar shortcomings. More fundamentally, the SEC’s reforms may substantially reduce the utility of MMFs for many investors, which could, in turn, affect the availability of short term credit.
The shape of MMF reform has been influenced by a turf war among regulators as the SEC has battled with bank regulators both about the need for additional reforms and about the structure and timing of those reforms. Bank regulators have been influential in shaping the terms of the debate by using banking rhetoric to frame the narrative of MMF fragility. This rhetoric masks a critical difference between banks and MMFs – asset segregation. Unlike banks, MMF sponsors have assets and operations that are separate from the assets of the MMF itself. This difference has caused the SEC to mistake sponsor support as a weakness rather than a key stability-enhancing feature. As a result, the SEC mistakenly adopted reforms that burden sponsor support instead of encouraging it.
As this article explains, required sponsor support offers a novel and simple regulatory solution to MMF fragility. Accordingly this article proposes that the SEC require MMF sponsors explicitly to guarantee the $1 share price. Taking sponsor support out of the shadows embraces rather than ignores the advantage that MMFs offer over banks through asset partitioning. At the same time, sponsor support harnesses market discipline as a constraint against MMF risk-taking and moral hazard.
How much additional tax revenue can the government generate by increasing labor income taxes? In this paper we provide a quantitative answer to this question, and study the importance of the progressivity of the tax schedule for the ability of the government to generate tax revenues. We develop a rich overlapping generations model featuring an explicit family structure, extensive and intensive margins of labor supply, endogenous accumulation of labor market experience as well as standard intertemporal consumption-savings choices in the presence of uninsurable idiosyncratic labor productivity risk. We calibrate the model to US macro, micro and tax data and characterize the labor income tax Laffer curve under the current choice of the progressivity of the labor income tax code as well as when varying progressivity. We find that more progressive labor income taxes significantly reduce tax revenues. For the US, converting to a flat tax code raises the peak of the Laffer curve by 6%, whereas converting to a tax system with progressivity similar to Denmark would lower the peak by 7%. We also show that, relative to a representative agent economy tax revenues are less sensitive to the progressivity of the tax code in our economy. This finding is due to the fact that labor supply of two earner households is less elastic (along the intensive margin) and the endogenous accumulation of labor market experience makes labor supply of females less elastic (around the extensive margin) to changes in tax progressivity.
US data and new stockholding data from fifteen European countries and China exhibit a common pattern: stockholding shares increase in household income and wealth. Yet, there is a multitude of numbers to match through models. Using a single utility function across households (parsimony), we suggest a strategy for fitting stockholding numbers, while replicating that saving rates increase in wealth, too. The key is introducing subsistence consumption to an Epstein-Zin-Weil utility function, creating endogenous risk-aversion differences across rich and poor. A closed-form solution for the model with insurable labor-income risk serves as calibration guide for numerical simulations with uninsurable labor-income risk.
There has been a considerable debate about whether disaster models can rationalize the equity premium puzzle. This is because empirically disasters are not single extreme events, but long-lasting periods in which moderate negative consumption growth realizations cluster. Our paper proposes a novel way to explain this stylized fact. By allowing for consumption drops that can spark an economic crisis, we introduce a new economic channel that combines long-run and short-run risk. First, we document that our model can match consumption data of several countries. Second, it generates a large equity risk premium even if consumption drops are of moderate size.
We analyze the implications of the structure of a network for asset prices in a general equilibrium model. Networks are represented via self- and mutually exciting jump processes, and the representative agent has Epstein-Zin preferences. Our approach provides a exible and tractable unifying foundation for asset pricing in networks. The model endogenously generates results in accordance with, e.g., the robust-yetfragile feature of financial networks shown in Acemoglu, Ozdaglar, and Tahbaz-Salehi (2014) and the positive centrality premium documented in Ahern (2013). We also show that models with simpler preference assumptions cannot generate all these findings simultaneously.
Using data from the US Health and Retirement Study, we study the causal effect of increased health insurance coverage through Medicare and the associated reduction in health-related background risk on financial risk-taking. Given the onset of Medicare at age 65, we identify our effect of interest using a regression discontinuity approach. We find that getting Medicare coverage induces stockholding for those with at least some college education, but not for their less-educated counterparts. Hence, our results indicate that a reduction in background risk induces financial risk-taking in individuals for whom informational and pecuniary stock market participation costs are relatively low.
We examine both the degree and the structural stability of inflation persistence at different quantiles of the conditional inflation distribution. Previous research focused exclusively on persistence at the conditional mean of the inflation rate. As economic theory provides reasons for inflation persistence to differ across conditional quantiles, this is a potentially severe constraint. Conventional studies of inflation persistence cannot identify changes in persistence at selected quantiles that leave persistence at the median of the distribution unchanged. Based on post-war US data we indeed find robust evidence for a structural break in persistence at all quantiles of the inflation process in the early 1980s. While prior to the 1980s inflation was not mean reverting, quantile autoregression based unit root tests suggest that since the end of the Volcker disinflation the unit root can be rejected at every quantile of the conditional inflation distribution.
The European Central Bank (ECB) has finalized its comprehensive assessment of the solvency of the largest banks in the euro area and on October 26 disclosed the results of this assessment. In the present paper, Acharya and Steffen compare the outcomes of the ECB's assessment to their own benchmark stress tests conducted for 39 publically listed financial institutions that are also included in the ECB's regulatory review. The authors identify a negative correlation between their benchmark estimates for capital shortfalls and the regulatory capital shortfall, but a positive correlation between their benchmark estimates for losses under stress both in the banking book and in the trading book. They conclude that the regulatory stress test outcomes are potentially heavily affected by discretion of national regulators in measuring what is capital, and especially the use of risk-weighted assets in calculating the prudential capital requirement.
Robustness, validity, and significance of the ECB's asset quality review and stress test exercise
(2014)
As we are moving toward a eurozone banking union, the European Central Bank (ECB) is going to take over the regulatory oversight of 128 banks in November 2014. To that end, the ECB conducted a comprehensive assessment of these banks, which included an asset quality review (AQR) and a stress test. The fundamental question is how accurately will the financial condition of these banks have been assessed by the ECB when it commences its regulatory oversight? And, can the comprehensive assessment lead to a full repair of banks’ balance sheets so that the ECB takes over financially sound banks and is the necessary regulation in place to facilitate this? Overall, the evidence presented in this paper based on the design of the comprehensive assessment as well as own stress test exercises suggest that the ECB’s assessment might not comprehensively deal with the problems in the financial sector and risks may remain that will pose substantial threats to financial stability in the eurozone.
On average, "young" people underestimate whereas "old" people overestimate their chances to survive into the future. We adopt a Bayesian learning model of ambiguous survival beliefs which replicates these patterns. The model is embedded within a non-expected utility model of life-cycle consumption and saving. Our analysis shows that agents with ambiguous survival beliefs (i) save less than originally planned, (ii) exhibit undersaving at younger ages, and (iii) hold larger amounts of assets in old age than their rational expectations counterparts who correctly assess their survival probabilities. Our ambiguity-driven model therefore simultaneously accounts for three important empirical findings on household saving behavior.
This paper investigates extensions of the method of endogenous gridpoints (ENDGM) introduced by Carroll (2006) to higher dimensions with more than one continuous endogenous state variable. We compare three different categories of algorithms: (i) the conventional method with exogenous grids (EXOGM), (ii) the pure method of endogenous gridpoints (ENDGM) and (iii) a hybrid method (HYBGM). ENDGM comes along with Delaunay interpolation on irregular grids. Comparison of methods is done by evaluating speed and accuracy. We find that HYBGM and ENDGM both dominate EXOGM. In an infinite horizon model, ENDGM also always dominates HYBGM. In a finite horizon model, the choice between HYBGM and ENDGM depends on the number of gridpoints in each dimension. With less than 150 gridpoints in each dimension ENDGM is faster than HYBGM, and vice versa. For a standard choice of 25 to 50 gridpoints in each dimension, ENDGM is 1.4 to 1.7 times faster than HYBGM in the finite horizon version and 2.4 to 2.5 times faster in the infinite horizon version of the model.
When markets are incomplete, social security can partially insure against idiosyncratic and aggregate risks. We incorporate both risks into an analytically tractable model with two overlapping generations and demonstrate that they interact over the life-cycle. The interactions appear even though the two risks are orthogonal and they amplify the welfare consequences of introducing social security. On the one hand, the interactions increase the welfare benefits from insurance. On the other hand, they can in- or decrease the welfare costs from crowding out of capital formation. This ambiguous effect on crowding out means that the net effect of these two channels is positive, hence the interactions of risks increase the total welfare benefits of social security.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.