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163
A PreferredHabitat Model of the Term Structure of Interest Rates,” NBER Working Paper 15487
, 2009
"... We model the term structure of interest rates as resulting from the interaction between investor clienteles with preferences for specific maturities and riskaverse arbitrageurs. Because arbitrageurs are risk averse, shocks to clienteles ’ demand for bonds affect the term structure— and constitute a ..."
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Cited by 90 (5 self)
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We model the term structure of interest rates as resulting from the interaction between investor clienteles with preferences for specific maturities and riskaverse arbitrageurs. Because arbitrageurs are risk averse, shocks to clienteles ’ demand for bonds affect the term structure— and constitute an additional determinant of bond prices to current and expected future short rates. At the same time, because arbitrageurs render the term structure arbitragefree, demand effects satisfy noarbitrage restrictions and can be quite different from the underlying shocks. We show that the preferredhabitat view of the term structure generates a rich set of implications for bond risk premia, the effects of demand shocks and of shocks to shortrate expectations, the economic role of carry trades, and the transmission of monetary policy.
Rare Disasters, Asset Prices and Welfare Costs. American Economic Review, forthcoming
, 2009
"... A representativeconsumer model with EpsteinZinWeil preferences and i.i.d. shocks, including rare disasters, accords with observed equity premia and riskfree rates if the coefficient of relative risk aversion equals 3–4. If the intertemporal elasticity of substitution exceeds one, an increase in ..."
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Cited by 87 (0 self)
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A representativeconsumer model with EpsteinZinWeil preferences and i.i.d. shocks, including rare disasters, accords with observed equity premia and riskfree rates if the coefficient of relative risk aversion equals 3–4. If the intertemporal elasticity of substitution exceeds one, an increase in uncertainty lowers the pricedividend ratio for equity, and a rise in the expected growth rate raises this ratio. Calibrations indicate that society would willingly reduce GDP by around 20 percent each year to eliminate rare disasters. The welfare cost from usual economic fluctuations is much smaller, though still important, corresponding to lowering GDP by about 1.5 percent each year. (JEL E13, E21, E22, E32) In a previous study, Barro (2006), I used the Thomas A. Rietz (1988) idea of rare economic disasters to explain the equity premium and related assetpricing puzzles. My quantitative examination of large macroeconomic contractions in 35 countries during the twentieth century suggested a disaster probability of roughly 2 percent per year. The size distribution of GDP contractions during these events ranged between 15 percent (the arbitrary lower bound) and over 60
The Term Structure of Interest Rates in a DSGE Model with Recursive Preferences
, 2010
"... We solve a dynamic stochastic general equilibrium (DSGE) model in which the representative household has Epstein and Zin recursive preferences. The parameters governing preferences and technology are estimated by means of maximum likelihood using macroeconomic data and asset prices, with a particul ..."
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Cited by 31 (2 self)
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We solve a dynamic stochastic general equilibrium (DSGE) model in which the representative household has Epstein and Zin recursive preferences. The parameters governing preferences and technology are estimated by means of maximum likelihood using macroeconomic data and asset prices, with a particular focus on the term structure of interest rates. We estimate a large risk aversion, an elasticity of intertemporal substitution higher than one, and substantial adjustment costs. Furthermore, we identify the tensions within the model by estimating it on subsets of these data. We conclude by pointing out potential extensions that might improve the model’s fit.
Discount Rates
 Journal of Finance
, 2011
"... I argue that characterizing discount rate variation over time and across assets has replaced informational efficiency as the central organizing question of asset pricing research. I survey the facts: in the last 40 years we have learned that discount rates vary dramatically. Most views of the world ..."
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Cited by 30 (7 self)
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I argue that characterizing discount rate variation over time and across assets has replaced informational efficiency as the central organizing question of asset pricing research. I survey the facts: in the last 40 years we have learned that discount rates vary dramatically. Most views of the world changed 100%: we thought 100 % of the variation in market dividend yields was due to variation in expected cashflows; now we know 100 % is due to variation in discount rates. We thought 100 % of the crosssectional variation in expected returns came from the CAPM, now we think that’s about zero and a zoo of new factors describes the cross section. I show how timeseries, crosssection, regression, and portfolio approaches are really the same, and think about how the empirical project can achieve a needed unification. I survey theories. I break discountrate theories into categories. Frictionless theories include macro, both consumption and investmentfocused, and behavioral approaches. Theoreis that focus on frictions include segemented markets, institutional frictions and liquidity. I survey applications. The simple facts of large variation in risk premiums has and will
2013): “Uncertainty Shocks are Aggregate Demand Shocks,” Federal Reserve Bank of San Francisco, Working Paper
"... Abstract. We present empirical evidence and a theoretical argument that uncertainty shocks act like a negative aggregate demand shock, which raises unemployment and lowers inflation. We measure uncertainty using survey data from the United States and the United Kingdom. We estimate the macroeconomic ..."
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Cited by 28 (4 self)
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Abstract. We present empirical evidence and a theoretical argument that uncertainty shocks act like a negative aggregate demand shock, which raises unemployment and lowers inflation. We measure uncertainty using survey data from the United States and the United Kingdom. We estimate the macroeconomic effects of uncertainty shocks in a vector autoregression (VAR) model, exploiting the relative timing of the surveys and macroeconomic data releases for identification. Our estimation reveals that uncertainty shocks accounted for at least one percentage point increases in unemployment in the Great Recession and recovery, but did not contribute much to the 198182 recession. We present a DSGE model to show that, to understand the observed macroeconomic effects of uncertainty shocks, it is essential to have both labor search frictions and nominal rigidities. I.
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 28 (6 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.
Disaster risk and business cycles
, 2009
"... This paper proposes a tractable business cycle model with large, volatile, and countercyclical risk premia. Risk premia are driven by a small, exogenously timevarying risk of economic disaster, and macroeconomic aggregates respond to this timevarying risk. The model is consistent with the second m ..."
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Cited by 28 (0 self)
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This paper proposes a tractable business cycle model with large, volatile, and countercyclical risk premia. Risk premia are driven by a small, exogenously timevarying risk of economic disaster, and macroeconomic aggregates respond to this timevarying risk. The model is consistent with the second moments of quantities, of asset returns, and matches well the relations between quantities and asset prices. An increase in the probability of disaster leads to a collapse of investment and a recession, with no current or future change in productivity. Demand for precautionary savings increases, leading yields on safe assets to fall, while spreads on risky securities increase. To assess the empirical validity of the model, I infer the probability of disaster from observed asset prices and feed it into the model. The variation over time in this probability appears to account for a signi…cant fraction of business cycle dynamics, especially sharp downturns in investment and output such as the last quarter of 2008. This is consistent with the thenwidespread fear of a repeat of the
Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle
, 2009
"... Empirically, highinterestrate currencies tend to appreciate in the future relative to lowinterestrate currencies instead of depreciating as uncovered interest rate parity (UIP) states. The explanation for the UIP puzzle that I pursue in this paper is that the agents' beliefs are systemati ..."
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Cited by 25 (3 self)
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Empirically, highinterestrate currencies tend to appreciate in the future relative to lowinterestrate currencies instead of depreciating as uncovered interest rate parity (UIP) states. The explanation for the UIP puzzle that I pursue in this paper is that the agents' beliefs are systematically distorted. This perspective receives some support from an extended empirical literature using survey data. I construct a model of exchange rate determination in which ambiguityaverse agents need to solve a filtering problem to form forecasts but face signals about the timevarying hidden state that are of uncertain precision. In the presence of such uncertainty, ambiguityaverse agents take a worstcase evaluation of this precision and respond stronger to bad news than to good news about the payoffs of their investment strategies. Importantly, because of this endogenous systematic underestimation, agents in the next periods will perceive on average positive innovations about the payoffs which will make them reevaluate upwards the profitability of the strategy. As a result, the model's dynamics imply significant expost departures from UIP as equilibrium outcomes. In addition to providing a resolution to the UIP puzzle, the model predicts, consistent with the data, negative skewness and excess kurtosis for currency excess returns and positive average payoffs even for hedged positions.
On the Size Distribution of Macroeconomic Disasters
 Ursua (2008a): “Macroeconomic Crises since 1870,” Brookings Papers on Economic Activity
"... In the raredisasters setting, a key determinant of the equity premium is the size distribution of macroeconomic disasters, gauged by proportionate declines in per capita consumption or GDP. The longterm nationalaccounts data for up to 36 countries provide a large sample of disaster events of magn ..."
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Cited by 24 (3 self)
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In the raredisasters setting, a key determinant of the equity premium is the size distribution of macroeconomic disasters, gauged by proportionate declines in per capita consumption or GDP. The longterm nationalaccounts data for up to 36 countries provide a large sample of disaster events of magnitude 10 % or more. For this sample, a powerlaw density provides a good fit to the distribution of the ratio of normal to disaster consumption or GDP. The key parameter of the size distribution is the uppertail exponent, α, estimated to be near 5, with a 95 % confidence interval between 31/2 and 7. The equity premium involves a race between α and the coefficient of relative risk aversion, γ. A higher α signifies a thinner tail and, therefore, a lower equity premium, whereas a higher γ implies a higher equity premium. The equity premium is finite if α1>γ. To accord with the observed average unlevered equity premium of around 5%, we get a point estimate for γ close to 3, with a 95 % confidence interval of roughly 2 to 4. * This research has been supported by the National Science Foundation. We appreciate helpful comments from Xavier Gabaix, Rustam Ibragimov, Chris Sims, Jose Ursua, and Marty Weitzman. Recent research builds on the raredisasters idea of Rietz (1988) to explain the longterm
The CrossSection and TimeSeries of Stock and Bond Returns. Unpublished Working Paper.
, 2010
"... Abstract We propose an arbitragefree stochastic discount factor (SDF) model that jointly prices the crosssection of returns on portfolios of stocks sorted on booktomarket dimension, the crosssection of government bonds sorted by maturity, the dynamics of bond yields, and time series variation ..."
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Cited by 22 (3 self)
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Abstract We propose an arbitragefree stochastic discount factor (SDF) model that jointly prices the crosssection of returns on portfolios of stocks sorted on booktomarket dimension, the crosssection of government bonds sorted by maturity, the dynamics of bond yields, and time series variation in expected stock and bond returns. Its pricing factors are motivated by a decomposition of the pricing kernel into a permanent and a transitory component. Shocks to the transitory component govern the level of the term structure of interest rates and price the crosssection of bond returns. Shocks to the permanent component govern the dividend yield and price the average equity returns. Third, shocks to the relative contribution of the transitory component to the conditional variance of the SDF govern the CochranePiazzesi (2005, CP) factor, a strong predictor of future bond returns. These shocks price the crosssection of booktomarket sorted stock portfolios. Because the CP factor is a strong predictor of economic activity oneto twoyears ahead, shocks to the importance of the transitory component signal improving economic conditions. Value stocks are riskier and carry a return premium because they are more exposed to such shocks.