Rare disasters, asset prices, and welfare costs

"... We study a dynamic model in which the interaction between debt accumulation and asset prices magnifies credit booms and busts. We find that borrowers do not internalize these feedback effects and therefore suffer from excessively large booms and busts in both credit flows and asset prices. We show t ..."

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We study a dynamic model in which the interaction between debt accumulation and asset prices magnifies credit booms and busts. We find that borrowers do not internalize these feedback effects and therefore suffer from excessively large booms and busts in both credit flows and asset prices. We show that a Pigouvian tax on borrowing may induce borrowers to internalize these externalities and increase welfare. We calibrate the model with reference to (1) the US small and medium-sized enterprise sector and (2) the household sector and find the optimal tax to be countercyclical in both cases, dropping to zero in busts and rising to approximately half a percentage point of the amount of debt outstanding during booms.

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2011a, Financial crises, credit booms, and external imbalances: 140 years of lessons, IMF Economic Review

by Moritz Schularick, Alan M. Taylor, Moritz Schularick, John F. Kennedy, Alan M. Taylor

"... Do external imbalances increase the risk of financial crises? In this paper, we study the experience of 14 developed countries over 140 years (1870–2008). We exploit our long-run dataset in a number of different ways. First, we apply new statistical tools to describe the temporal and spatial pattern ..."

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Do external imbalances increase the risk of financial crises? In this paper, we study the experience of 14 developed countries over 140 years (1870–2008). We exploit our long-run dataset in a number of different ways. First, we apply new statistical tools to describe the temporal and spatial patterns of crises and identify five episodes of global financial instability in the past 140 years. Second, we study the macroeconomic dynamics before crises and show that credit growth tends to be elevated and natural interest rates depressed in the run-up to global financial crises. Third, we show that recessions associated with crises lead to deeper slumps and stronger turnarounds in imbalances than during normal recessions. Finally, we ask to what extent external imbalances help predict financial crises. Our overall result is that credit growth emerges as the single best predictor of financial instability. External imbalances have played an additional role, but more so in the pre-WWII era of low financialization than today. • Keywords: financial instability, global imbalances, capital flows, correct classification frontier.

Overborrowing, financial crises and macro-prudential policy. Working Papers .

by Javier Bianchi , Enrique G Mendoza , Rui Albuquerque , Kenza Benzima , Charles Engel , Tasos Karantounias , Tim Kehoe , Anton Korinek , Amartya Lahiri , Vincenzo Quadrini , Jaume , 2012

"... Abstract This paper studies overborrowing, financial crises and macro-prudential policy in an equilibrium model of business cycles and asset prices with collateral constraints. Agents in a decentralized competitive equilibrium do not internalize the negative effects of asset fire-sales on the value ..."

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Abstract This paper studies overborrowing, financial crises and macro-prudential policy in an equilibrium model of business cycles and asset prices with collateral constraints. Agents in a decentralized competitive equilibrium do not internalize the negative effects of asset fire-sales on the value of other agents' assets and hence they borrow "too much" ex ante, compared with a constrained social planner who internalizes these effects. Average debt and leverage ratios are slightly larger in the competitive equilibrium, but the incidence and magnitude of financial crises are much larger. Excess asset returns, Sharpe ratios and the market price of risk are also much larger. State-contingent taxes on debt and dividends of about 1 and -0.5 percent on average respectively support the planner's allocations as a competitive equilibrium and increase social welfare. JEL classification: D62, E32, E44, F32, F41

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Tails, fears and risk premia

by Tim Bollerslev, Viktor Todorov - JOURNAL OF FINANCE , 2009

"... We show that the compensation for rare events accounts for a large fraction of the equity and variance risk premia in the S&P 500 market index. The probability of rare events vary significantly over time, increasing in periods of high market volatility, but the risk premium for tail events canno ..."

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We show that the compensation for rare events accounts for a large fraction of the equity and variance risk premia in the S&P 500 market index. The probability of rare events vary significantly over time, increasing in periods of high market volatility, but the risk premium for tail events cannot solely be explained by the level of the volatility. Our empirical investigations are essentially model-free. We estimate the expected values of the tails under the statistical probability measure from “medium” size jumps in high-frequency intraday prices and an extreme value theory approximation for the corresponding jump tail density. Our estimates for the risk-neutral expectations are based on short maturity out-of-the money options and new model-free option implied variation measures explicitly designed to separate the tail probabilities. At a general level, our results suggest that any satisfactory equilibrium based asset pricing model must be able to generate large and time-varying compensations for fears of disasters.

A Macroeconomic Model of Endogenous Systemic Risk Taking,CEPR Discussion Paper DP9134

by David Martinez-Miera , Javier Suarez Cemfi , Cepr , Pariès Matthieu Darracq , Giovanni Dell'ariccia , Gianni De Nicolo , Martin El-Lison , Helmut Elsinger , Carlos González-Aguado , Hans Gersbach , Frederic Malherbe , Claudio Michelacci , Enrico Perotti , Rafael Repullo , Diego Rodriguez-Palenzuela , Ruben Segura , Nicholas Trachter , Alexandros , 2012

"... Abstract We analyze banks' systemic risk taking in a simple dynamic general equilibrium model. Banks collect funds from savers and make loans to firms. Banks are owned by risk-neutral bankers who provide the equity needed to comply with capital requirements. Bankers decide their (unobservable) ..."

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Abstract We analyze banks' systemic risk taking in a simple dynamic general equilibrium model. Banks collect funds from savers and make loans to firms. Banks are owned by risk-neutral bankers who provide the equity needed to comply with capital requirements. Bankers decide their (unobservable) exposure to systemic shocks by trading off risk-shifting gains with the value of preserving their capital after a systemic shock. Capital requirements reduce credit and output in "normal times," but also reduce banks' systemic risk taking and, hence, the losses caused by systemic shocks. Under our calibration of the model, optimal capital requirements are quite high, have a sizeable negative impact on GDP, do not require counter-cyclical adjustment, and should be gradually introduced.

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An equilibrium asset pricing model with labor markets search. Working Paper

by Lars-Alexander Kuehn , Nicolas Petrosky-Nadeau , Lu Zhang , Ravi Bansal , Frederico Belo , Jonathan Berk , Nicholas Bloom , Andrew Chen , Jack Favilukis , Michael Gallmeyer , Urban Jermann , Xiaoji Lin , Laura Xiaolei Liu , Stavros Panageas , Vincenzo Quadrini , René Stulz , Neng Wang , Michael Weisbach , Ingrid Werner , Amir Yaron , 2010

"... Abstract Frictions in the labor market are important for understanding the equity premium in the financial market. We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences. The model produces realistic equity premium a ..."

Abstract - Cited by 16 (2 self) - Add to MetaCart

Abstract Frictions in the labor market are important for understanding the equity premium in the financial market. We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences. The model produces realistic equity premium and stock market volatility, as well as low interest rate and interest rate volatility. The equity premium is also countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, three key ingredients in the model (small profits, large job flows, and matching frictions) combine to give rise endogenously to rare economic disastersà la

Numerically stable and accurate stochastic simulation approaches for solving dynamic models

by Kenneth L. Judd, Lilia Maliar, Serguei Maliar - Quantitative Economics , 2011

"... We develop numerically stable and accurate stochastic simulation approaches for solving dynamic economic models. First, instead of standard least-squares approximation methods, we examine a variety of alternatives, including leastsquares methods using singular value decomposition and Tikhonov regula ..."

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We develop numerically stable and accurate stochastic simulation approaches for solving dynamic economic models. First, instead of standard least-squares approximation methods, we examine a variety of alternatives, including leastsquares methods using singular value decomposition and Tikhonov regularization, least-absolute deviations methods, and principal component regression method, all of which are numerically stable and can handle ill-conditioned problems. Second, instead of conventional Monte Carlo integration, we use accurate quadrature and monomial integration. We test our generalized stochastic simulation algorithm (GSSA) in three applications: the standard representative–agent neoclassical growth model, a model with rare disasters, and a multicountry model with hundreds of state variables. GSSA is simple to program, and MATLAB codes are provided.

Rare disasters, asset prices, and welfare costs (2009)

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