Refine
Year of publication
- 2013 (8) (remove)
Document Type
- Working Paper (8)
Language
- English (8)
Has Fulltext
- yes (8)
Is part of the Bibliography
- no (8)
Keywords
- Contagion (2)
- General Equilibrium (2)
- Asset Allocation (1)
- Asset Pricing (1)
- Consumption hump (1)
- Contagion Risk (1)
- Filtering (1)
- Firm valuation (1)
- Hidden State (1)
- Nonlinear Filtering (1)
Institute
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on results from the true model. We apply our method to a calibrated affine model and fine that relative wealth equivalent losses are below 1.16% if the jump size is stochastic and below 1% if the jump size is constant and γ ≥ 5. We perform robustness checks for various levels of risk-aversion, expected jump size, and jump intensity.
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.
This paper analyzes the equilibrium pricing implications of contagion risk in a Lucas-tree economy with recursive preferences and jumps. We introduce a new economic channel allowing for the possibility that endowment shocks simultaneously trigger a regime shift to a bad economic state. We document that these contagious jumps have far-reaching asset pricing implications. The risk premium for such shocks is superadditive, i.e. it is 2.5\% larger than the sum of the risk premia for pure endowment shocks and regime switches. Moreover, contagion risk reduces the risk-free rate by around 0.5\%. We also derive semiclosed-form solutions for the wealth-consumption ratio and the price-dividend ratios in an economy with two Lucas trees and analyze cross-sectional effects of contagion risk qualitatively. We find that heterogeneity among the assets with respect to contagion risk can increase risk premia disproportionately. In particular, big assets with a large exposure to contagious shocks carry significantly higher risk premia.
This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that (average) Tobin's Q increases with firm-level volatility. However, the significance mainly comes from R&D firms, which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we also document that only idiosyncratic volatility (ivol) has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Single sorting according to the size of idiosyncratic volatility, we only find a significant ivol anomaly for non-R&D portfolios, whereas in a four-factor model the portfolio alphas of R&D portfolios are all positive. Double sorting on idiosyncratic volatility and R&D expenses also reveals these differences between R&D and non-R&D firms. To simultaneously control for several explanatory variables, we also run panel regressions of portfolio alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses.
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.
We show that the optimal consumption of an individual over the life cycle can have the hump shape (inverted U-shape) observed empirically if the preferences of the individual exhibit internal habit formation. In the absence of habit formation, an impatient individual would prefer a decreasing consumption path over life. However, because of habit formation, a high initial consumption would lead to high required consumption in the future. To cover the future required consumption, wealth is set aside, but the necessary amount decreases with age which allows consumption to increase in the early part of life. At some age, the impatience outweighs the habit concerns so that consumption starts to decrease. We derive the optimal consumption strategy in closed form, deduce sufficient conditions for the presence of a consumption hump, and characterize the age at which the hump occurs. Numerical examples illustrate our findings. We show that our model calibrates well to U.S. consumption data from the Consumer Expenditure Survey.
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.