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63
Do Peso Problems Explain the Returns to the Carry Trade
 Review of Financial Studies
, 2011
"... We study the properties of the carry trade, a currency speculation strategy in which an investor borrows lowinterestrate currencies and lends highinterestrate currencies. This strategy generates payoffs that are on average large and uncorrelated with traditional risk factors. We argue that thes ..."
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Cited by 83 (2 self)
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We study the properties of the carry trade, a currency speculation strategy in which an investor borrows lowinterestrate currencies and lends highinterestrate currencies. This strategy generates payoffs that are on average large and uncorrelated with traditional risk factors. We argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs. (JEL F31) The forward exchange rate is a biased forecaster of the future spot exchange rate. This fact is often referred to as the “forwardpremium puzzle. ” We study the properties of a widely used currency speculation strategy, known as the carry trade, which exploits this puzzle. This strategy involves selling currencies forward that are at a forward premium and buying currencies forward that are at a forward discount. Transaction costs aside, this strategy is equivalent to borrowing lowinterestrate currencies in order to lend highinterestrate currencies, without hedging the associated currency risk. Consistent with results in the literature, we find that the carry trade strategy applied to portfolios of currencies yields high average payoffs, as well as Sharpe ratios that are substantially higher than those associated with the U.S. stock market. This article is a substantially revised version of NBER Working Paper 12489, titled “The Returns to Currency
2011) “Fiscal stimulus in a monetary union: Evidence from US regions,” NBER Working Paper No
"... We use rich historical data on military procurement spending across U.S. regions to estimate the effects of government spending in a monetary union. Aggregate military buildups and drawdowns have differential effects across regions. We use this variation to estimate an “open economy relative multip ..."
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Cited by 66 (2 self)
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We use rich historical data on military procurement spending across U.S. regions to estimate the effects of government spending in a monetary union. Aggregate military buildups and drawdowns have differential effects across regions. We use this variation to estimate an “open economy relative multiplier ” of approximately 1.5. We develop a framework for interpreting this estimate and relating it to estimates of the standard closed economy aggregate multiplier. The closed economy aggregate multiplier is highly sensitive to how strongly aggregate monetary and tax policy “leans against the wind. ” In contrast, our open economy relative multiplier “differences out ” these effects because different regions in the union share a common monetary and tax policy. Our estimates provide evidence in favor of models in which demand shocks can have large effects on output.
Disasters implied by equity index options
, 2009
"... We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with highorder cumulants: skewness, kurtosis, and so on. We show that highorder cumulan ..."
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Cited by 24 (5 self)
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We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with highorder cumulants: skewness, kurtosis, and so on. We show that highorder cumulants are quantitatively important in both representativeagent models with disasters and in a statistical pricing model estimated from equity index options. Option prices thus provide independent confirmation of the impact of extreme events on asset returns, but they imply a more modest distribution of them.
2012): “Does Uncertainty Reduce Growth? Using Disasters As Natural Experiments,”Stanford University, mimeo
"... A growing body of evidence suggests that uncertainty is counter cyclical, rising sharply in recessions and falling in booms. But what is the causal relationship between uncertainty and growth? To identify this we construct cross country panel data on stock market levels and volatility as proxies for ..."
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Cited by 12 (0 self)
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A growing body of evidence suggests that uncertainty is counter cyclical, rising sharply in recessions and falling in booms. But what is the causal relationship between uncertainty and growth? To identify this we construct cross country panel data on stock market levels and volatility as proxies for the first and second moments of business conditions. We then use natural disasters, terrorist attacks and unexpected political shocks as instruments for our stock market proxies of first and second moment shocks. We find that both the first and second moments are highly significant in explaining GDP growth, with second moment shocks accounting for at least a half of the variation in growth. Variations in higher moments of stock market returns appear to have little impact on growth.
A theory of firm characteristics and stock returns: the role of investmentspecific shocks. Working paper
, 2012
"... We provide a theoretical model linking firm characteristics and expected returns. The key ingredient of our model is technological shocks embodied in new capital (IST shocks), which affect the profitability of new investments. Firms ’ exposure to IST shocks is endogenously determined by the fraction ..."
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Cited by 11 (4 self)
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We provide a theoretical model linking firm characteristics and expected returns. The key ingredient of our model is technological shocks embodied in new capital (IST shocks), which affect the profitability of new investments. Firms ’ exposure to IST shocks is endogenously determined by the fraction of firm value due to growth opportunities. In our structural model, several firm characteristics – Tobin’s Q, past investment, earningsprice ratios, market betas, and idiosyncratic volatility of stock returns – help predict the share of growth opportunities in the firm’s market value, and are therefore correlated with the firm’s exposure to IST shocks and risk premia. Our calibrated model replicates: i) the predictability of returns by firm characteristics; ii) the comovement of stock returns on firms with similar characteristics; iii) the failure of the CAPM to price portfolio returns of firms sorted on characteristics; iv) the timeseries predictability of market portfolio returns by aggregate investment and valuation ratios; and v) a downward sloping term structure of risk premia for dividend strips. Our model delivers testable predictions about the behavior of firmlevel real variables – investment and output growth – that are supported by the data.
Growthrate and uncertainty shocks in consumption: Crosscountry evidence’, NBER Working Paper
, 2012
"... We quantify the importance of longrun risks—persistent shocks to growth rates and uncertainty—in a panel of longterm aggregate consumption data for developed countries. We identify sizable and highly persistent world growthrate shocks as well as less persistent countryspecific growth rate shocks ..."
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Cited by 10 (0 self)
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We quantify the importance of longrun risks—persistent shocks to growth rates and uncertainty—in a panel of longterm aggregate consumption data for developed countries. We identify sizable and highly persistent world growthrate shocks as well as less persistent countryspecific growth rate shocks. The world growthrate shocks capture the productivity speedup and slowdown many countries experienced in the second half of the 20th century. We also identify large and persistent world shocks to uncertainty. Our world uncertainty process captures the large but uneven rise and fall of volatility that occurred over the course of the 20th century. We find that negative shocks to growth rates are correlated with shocks that increase uncertainty. Our estimates based on macroeconomic data alone line up well with earlier calibrations of the longrun risks model designed to match asset pricing data. We document how these dynamics, combined with EpsteinZinWeil preferences, help explain a number of asset pricing puzzles.
Rare Disasters and Exchange Rates
, 2008
"... We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary num ..."
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Cited by 10 (0 self)
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We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary number of countries. In the model, rare worldwide disasters can occur and affect each country’s productivity. Each country’s exposure to disaster risk varies over time according to a meanreverting process. Risky countries command high risk premia: they feature a depreciated exchange rate and a high interest rate. As their risk premium mean reverts, their exchange rate appreciates. Therefore, currencies of high interest rate countries appreciate on average. To make the notion of disaster risk more implementable, we show how options prices might in principle uncover latent disaster risk, and help forecast exchange rate movements. We then extend the framework to incorporate two factors: a disaster risk factor, and a business cycle factor. We calibrate the model and obtain quantitatively realistic values for the volatility of the exchange rate, the forward premium puzzle regression coefficients, and nearrandom walk exchange rate dynamics. Finally, we solve a model of stock markets across countries, which yields a series of predictions about the joint behavior of exchange rates, bonds, options and stocks across countries. The evidence from the options market appears to be supportive of the
Sources of entropy in representative agent models
, 2011
"... We propose two performance measures for asset pricing models and apply them to representative agent models with recursive preferences, habits, and jumps. The measures describe the pricing kernel’s dispersion (the entropy of the title) and dynamics (horizon dependence, a measure of how entropy varies ..."
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Cited by 9 (3 self)
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We propose two performance measures for asset pricing models and apply them to representative agent models with recursive preferences, habits, and jumps. The measures describe the pricing kernel’s dispersion (the entropy of the title) and dynamics (horizon dependence, a measure of how entropy varies over different time horizons). We show how each model generates entropy and horizon dependence, and compare their magnitudes to estimates derived from asset returns. This exercise — and transparent loglinear approximations — clarify the mechanisms underlying these models. It also reveals, in some cases, tension between entropy, which should be large enough to account for observed excess returns, and horizon dependence, which should be small enough to account for mean yield spreads.
Learning about Consumption Dynamics
, 2010
"... This paper studies the asset pricing implications of Bayesian learning about the parameters, states, and models determining aggregate consumption dynamics. Our approach is empirical and focuses on the quantitative implications of learning in realtime using post World War II consumption data. We cha ..."
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Cited by 8 (0 self)
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This paper studies the asset pricing implications of Bayesian learning about the parameters, states, and models determining aggregate consumption dynamics. Our approach is empirical and focuses on the quantitative implications of learning in realtime using post World War II consumption data. We characterize this learning process and provide empirical evidence that revisions in beliefs stemming from parameter and model uncertainty are signi…cantly related to realized aggregate equity returns. Further, we show that beliefs regarding the conditional moments of consumption growth are strongly timevarying and exhibit business cycle and/or longrun ‡uctuations. Much of the longrun behavior is unanticipated ex ante. We embed these subjective beliefs in a general equilibrium model and …nd that about half of the post WorldWar II observed equity market risk premium and much of the observed return predictability are due to unexpected revisions in beliefs about parameters and models governing consumption dynamics.