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#### Institute

- Wirtschaftswissenschaften (18) (remove)

- Systemic risk in the financial sector: what can we learn from option markets? (2013)
- In this paper, we propose a novel approach on how to estimate systemic risk and identify its key determinants. For all US financial companies with publicly traded equity options, we extract their option-implied value-at-risks (VaRs) and measure the spillover effects between individual company VaRs and the option-implied VaR of an US financial index. First, we study the spillover effect of increasing company risks on the financial sector. Second, we analyze which companies are most affected if the tail risk of the financial sector increases. We find that key accounting and market valuation metrics such as size, leverage, balance sheet composition, market-to-book ratio and earnings have a significant influence on the systemic risk profile of a financial institution. In contrast to earlier studies, the employed panel vector autoregression (PVAR) estimator allows for a causal interpretation of the results.

- A dynamic programming approach to constrained portfolios (2012)
- This paper studies constrained portfolio problems that may involve constraints on the probability or the expected size of a shortfall of wealth or consumption. Our first contribution is that we solve the problems by dynamic programming, which is in contrast to the existing literature that applies the martingale method. More precisely, we construct the non-separable value function by formalizing the optimal constrained terminal wealth to be a (conjectured) contingent claim on the optimal non-constrained terminal wealth. This is relevant by itself, but also opens up the opportunity to derive new solutions to constrained problems. As a second contribution, we thus derive new results for non-strict constraints on the shortfall of inter¬mediate wealth and/or consumption.

- Partial information about contagion risk, self-exciting processes and portfolio optimization (2013)
- This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.

- Foundations of continuous-time recursive utility : differentiability and normalization of certainty equivalents (2009)
- This paper relates recursive utility in continuous time to its discrete-time origins and provides a rigorous and intuitive alternative to a heuristic approach presented in [Duffie, Epstein 1992], who formally define recursive utility in continuous time via backward stochastic differential equations (stochastic differential utility). Furthermore, we show that the notion of Gâteaux differentiability of certainty equivalents used in their paper has to be replaced by a different concept. Our approach allows us to address the important issue of normalization of aggregators in non-Brownian settings. We show that normalization is always feasible if the certainty equivalent of the aggregator is of expected utility type. Conversely, we prove that in general L´evy frameworks this is essentially also necessary, i.e. aggregators that are not of expected utility type cannot be normalized in general. Besides, for these settings we clarify the relationship of our approach to stochastic differential utility and, finally, establish dynamic programming results. JEL Classifications: D81, D91, C61

- Optimal housing, consumption, and investment decisions over the life-cycle (2009)
- We provide explicit solutions to life-cycle utility maximization problems simultaneously involving dynamic decisions on investments in stocks and bonds, consumption of perishable goods, and the rental and the ownership of residential real estate. House prices, stock prices, interest rates, and the labor income of the decision-maker follow correlated stochastic processes. The preferences of the individual are of the Epstein-Zin recursive structure and depend on consumption of both perishable goods and housing services. The explicit consumption and investment strategies are simple and intuitive and are thoroughly discussed and illustrated in the paper. For a calibrated version of the model we find, among other things, that the fairly high correlation between labor income and house prices imply much larger life-cycle variations in the desired exposure to house price risks than in the exposure to the stock and bond markets. We demonstrate that the derived closed-form strategies are still very useful if the housing positions are only reset infrequently and if the investor is restricted from borrowing against future income. Our results suggest that markets for REITs or other financial contracts facilitating the hedging of house price risks will lead to non-negligible but moderate improvements of welfare. JEL-Classification: G11, D14, D91, C6

- What is the impact of stock market contagion on an investor's portfolio choice? (2009)
- Stocks are exposed to the risk of sudden downward jumps. Additionally, a crash in one stock (or index) can increase the risk of crashes in other stocks (or indices). Our paper explicitly takes this contagion risk into account and studies its impact on the portfolio decision of a CRRA investor both in complete and in incomplete market settings. We find that the investor significantly adjusts his portfolio when contagion is more likely to occur. Capturing the time dimension of contagion, i.e. the time span between jumps in two stocks or stock indices, is thus of first-order importance when analyzing portfolio decisions. Investors ignoring contagion completely or accounting for contagion while ignoring its time dimension suffer large and economically significant utility losses. These losses are larger in complete than in incomplete markets, and the investor might be better off if he does not trade derivatives. Furthermore, we emphasize that the risk of contagion has a crucial impact on investors' security demands, since it reduces their ability to diversify their portfolios. JEL-Classification: G12, G13

- Investment, income, incompleteness (2009)
- The utility-maximizing consumption and investment strategy of an individual investor receiving an unspanned labor income stream seems impossible to find in closed form and very dificult to find using numerical solution techniques. We suggest an easy procedure for finding a specific, simple, and admissible consumption and investment strategy, which is near-optimal in the sense that the wealthequivalent loss compared to the unknown optimal strategy is very small. We first explain and implement the strategy in a simple setting with constant interest rates, a single risky asset, and an exogenously given income stream, but we also show that the success of the strategy is robust to changes in parameter values, to the introduction of stochastic interest rates, and to endogenous labor supply decisions. JEL-Classification: G11

- Asset Pricing Under Uncertainty About Shock Propagation (2013)
- We analyze the equilibrium in a two-tree (sector) economy with two regimes. The output of each tree is driven by a jump-diffusion process, and a downward jump in one sector of the economy can (but need not) trigger a shift to a regime where the likelihood of future jumps is generally higher. Furthermore, the true regime is unobservable, so that the representative Epstein-Zin investor has to extract the probability of being in a certain regime from the data. These two channels help us to match the stylized facts of countercyclical and excessive return volatilities and correlations between sectors. Moreover, the model reproduces the predictability of stock returns in the data without generating consumption growth predictability. The uncertainty about the state also reduces the slope of the term structure of equity. We document that heterogeneity between the two sectors with respect to shock propagation risk can lead to highly persistent aggregate price-dividend ratios. Finally, the possibility of jumps in one sector triggering higher overall jump probabilities boosts jump risk premia while uncertainty about the regime is the reason for sizeable diffusive risk premia.

- Financing asset growth (2013)
- In this paper we provide new evidence that corporate financing decisions are associated with managerial incentives to report high equity earnings. Managers rely most heavily on debt to finance their asset growth when their future earnings prospects are poor, when they are under pressure due to past declines in earnings, negative past stock returns, and excessively optimistic analyst earnings forecasts, and when the earnings yield is high relative to bond yields so that from an accounting perspective equity is ‘expensive’. Managers of high debt issuing firms are more likely to be newly appointed and also more likely to be replaced in subsequent years. Abnormal returns on portfolios formed on the basis of asset growth and debt issuance are strongly positively associated with the contemporaneous changes in returns on assets and on equity as well as with earnings surprises. This may account for the finding that debt issuance forecasts negative abnormal returns, since debt issuance also forecasts negative changes in returns on assets and on equity and negative earnings surprises. Different mechanisms appear to be at work for firms that retire debt.

- Asset pricing and consumption-portfolio choice with recursive utility and unspanned risk (2014)
- We study consumption-portfolio and asset pricing frameworks with recursive preferences and unspanned risk. We show that in both cases, portfolio choice and asset pricing, the value function of the investor/representative agent can be characterized by a specific semilinear partial differential equation. To date, the solution to this equation has mostly been approximated by Campbell-Shiller techniques, without addressing general issues of existence and uniqueness. We develop a novel approach that rigorously constructs the solution by a fixed point argument. We prove that under regularity conditions a solution exists and establish a fast and accurate numerical method to solve consumption-portfolio and asset pricing problems with recursive preferences and unspanned risk. Our setting is not restricted to affine asset price dynamics. Numerical examples illustrate our approach.