On robust estimation of the location parameter

This paper incorporates a time-varying intensity of disasters in the Rietz-Barro hypothesis that risk premia result from the possibility of rare, large disasters. During a disaster, an asset’s fundamental value falls by a time-varying amount. This in turn generates time-varying risk premia and thus volatile asset prices and return predictability. Using the recent technique of linearity-generating processes (Gabaix 2007), the model is tractable, and all prices are exactly solved in closed form. In the “variable rare disasters” framework, the following empirical regularities can be understood qualitatively: (i) equity premium puzzle (ii) risk-free rate-puzzle (iii) excess volatility puzzle (iv) predictability of aggregate stock market returns with price-dividend ratios (v) value premium (vi) often greater explanatory power of characteristics than covariances for asset returns (vii) upward sloping nominal yield curve (viiii) a steep yield curve predicts high bond excess returns and a fall in long term rates (ix) corporate bond spread puzzle (x) high price of deep out-of-the-money puts. I also provide a calibration in which those puzzles can be understood quantitatively as well. The fear of disaster can be interpreted literally, or can be viewed as a tractable way to model time-varying risk-aversion or investor sentiment. (JEL: E43, E44, G12)

/pdf/variable-rare-disasters-an-exactly-solved-framework-for-ten-5952lqpjej.pdf

Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance

This review article tries to answer four questions: (i) what are the stylized facts about uncertainty over time; (ii) why does uncertainty vary; (iii) do fluctuations in uncertainty matter; and (iv) did higher uncertainty worsen the Great Recession of 2007-2009? On the first question both macro and micro uncertainty appears to rise sharply in recessions. On the second question the types of exogenous shocks like wars, financial panics and oil price jumps that cause recessions appear to directly increase uncertainty, and uncertainty also appears to endogenously rise further during recessions. On the third question, the evidence suggests uncertainty is damaging for short-run investment and hiring, but there is some evidence it may stimulate longer-run innovation. Finally, in terms of the Great Recession, the large jump in uncertainty in 2008 potentially accounted for about one third of the drop in GDP.

/pdf/fluctuations-in-uncertainty-24yx3k9xcm.pdf

Fluctuations in Uncertainty

Why is the equity premium so high, and why are stocks so volatile? Why are stock returns in excess of government bill rates predictable? This paper proposes an answer to these questions based on a time-varying probability of a consumption disaster. In the model, aggregate consumption follows a normal distribution with low volatility most of the time, but with some probability of a consumption realization far out in the left tail. The possibility of this poor outcome substantially increases the equity premium, while time-variation in the probability of this outcome drives high stock market volatility and excess return predictability. THE MAGNITUDE OF THE expected excess return on stocks relative to bonds (the equity premium) constitutes one of the major puzzles in financial economics. As Mehra and Prescott (1985 )s how, the fl uctuations observed in the consumption growth rate over U.S. history predict an equity premium that is far too small, assuming reasonable levels of risk aversion. 1 One proposed explanation is that the return on equities is high to compensate investors for the risk of a rare disaster (Rietz (1988)). An open question has therefore been whether the risk is sufficiently high, and the rare disaster sufficiently severe, to quantitatively explain the equity premium. Recently, however, Barro (2006) shows that it is possible to explain the equity premium using such a model when the probability of a rare disaster is calibrated to international data on large economic declines. WhilethemodelsofRietz(1988)andBarro(2006)advanceourunderstanding

/pdf/can-time-varying-risk-of-rare-disasters-explain-aggregate-2rs1nexxfx.pdf

Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?

This paper quanties how variation in real economic activity and ination in the U.S. inuenced the market prices of level, slope, and curvature risks in U.S. Treasury markets. To accomplish this we develop a novel arbitrage-free DTSM in which macroeconomic risks{ in particular, real output and ination risks{ impact bond investment decisions separately from information about the shape of the yield curve. Estimates of our preferred macro-DTSM over the twenty-three year period from 1985 through 2007 reveal that unspanned macro risks explained a substantial proportion of the variation in forward terms premiums. Unspanned macro risks accounted for nearly 90% of the conditional variation in short-dated forward term premiums, with unspanned real economic growth being the key driving factor. Over horizons beyond three years, these eects were entirely attributable to unspanned ination. Using our model, we also reassess some of Chairman Bernanke’s remarks on the interplay between term premiums, the shape of the yield curve, and macroeconomic activity.

/pdf/risk-premiums-in-dynamic-term-structure-models-with-3vjigiidzh.pdf

Risk Premiums in Dynamic Term Structure Models with Unspanned Macro Risks

Measures of U.S. government policy approval, such as U.S. Presidential or Congressional ratings, are strongly related to persistent fluctuations in the dollar exchange rates. Contemporaneous correlations between approval ratings and the dollar value reach 50% against the advanced economy currencies, in real and nominal terms, in levels and multi-year changes. High approval ratings further forecast a decline in the dollar risk premium, a persistent increase in economic growth, and a reduction in future economic volatility several years in the future. We provide an illustrative economic model to interpret our empirical evidence. In the model, policy valuations are forward-looking and reflect net contributions of policy to economic growth. Policy valuations (approvals) increase at times of high policy-related growth and low policy-related uncertainty, which are the times of a strong dollar and low dollar risk premium.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID3090851_code2482091.pdf?abstractid=3090851&mirid=1

Government Policy Approval and Exchange Rates

Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into 'good' and 'bad' volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk.

Good and Bad Uncertainty: Macroeconomic and Financial Market Implications

http://public.econ.duke.edu/~get/wpapers/bt.pdf

Pricing of the time-change risks

We develop a novel measure of volatility pass-through to assess international propagation of output volatility shocks to macroeconomic aggregates, equity prices, and currencies. An increase in country's output volatility is associated with a decrease in its output, consumption, and net exports. The average consumption pass-through is 50% (a 1% increase in output volatility increases consumption volatility by 0.5%) and it increases to 70% for shocks originating in smaller countries. The equity volatility pass-through is 90%, whereas the link between volatility of currency and fundamentals is weak. A novel channel of risk sharing of volatility risks can explain our empirical findings.

Volatility Risk Pass-through

We develop a general equilibrium model in which income and dividends are smooth, but asset prices are subject to large moves (jumps). A prominent feature of the model is that the optimal decision of investors to learn the unobserved state triggers large asset-price jumps. We show that the learning choice is critically determined by preference parameters and the conditional volatility of income process. An important prediction of the model is that income volatility predicts future jumps, while the variation in the level of income does not. We find that indeed in the data large moves in returns are predicted by consumption volatility, but not by the changes in the consumption level. We show that the model can quantitatively capture these novel features of the data.

Ivan Shaliastovich

Papers

Government Policy Approval and Exchange Rates

Good and Bad Uncertainty: Macroeconomic and Financial Market Implications

Pricing of the time-change risks

Volatility Risk Pass-through

Learning and Asset-Price Jumps