DSpace Community: Salomon Center

Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarking in Money Management

Title: Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarkingin Money Management

Basak, Suleyman; Pavlova, Anna; Shapiro, Alex

Abstract: Money managers are rewarded for increasing the value of assets undermanagement, and predominately so in the mutual fund industry. Thiscompensation scheme gives the manager an implicit incentive to exploitthe well-documented positive fund-flows to relative-performancerelationship by manipulating her risk exposure. It also provides herwith an explicit incentive to manage the fund in accordance with her ownappetite for risk. In a dynamic asset allocation framework, we show thatas the year-end approaches, the interplay of these incentives inducesthe manager to optimally closely mimic the index, relative to which herperformance is evaluated, when the fund's year-to-date return is justsufficient to cause a higher expected flow. As she falls behind, shegradually increases her risk exposure (via leverage or short selling),reaching an extremum at a critical level of underperformance. Thispolicy results in economically significant deviations from investor'sdesired risk exposure, substantially impairing them. To better aligninvestors' and managers' incentives, investors or regulators can imposea benchmarking restriction on the fund manager, prohibiting a shortfallrelative to a certain reference portfolio to exceed a pre-specifiedlevel. The restriction tempers deviations from the investors' desiredrisk exposure in the states in which the manager is tempted to deviatethe most, and hence is beneficial. The analysis reveals how this riskmanagement restriction should be designed for the highest benefit to theinvestors. Our findings complement and refine results in the relatedliterature on risk taking incentives of mutual fund managers, and are atodds with previous work arguing against benchmarking.

The Declining Information Content of Dividend Announcements and the Effect of Institutional Holdings

Title: The Declining Information Content of Dividend Announcements and theEffect of Institutional Holdings

Amihud, Yakov; Li, Kefei

Abstract: We propose an explanation for the "disappearing dividend"phenomenon: the decline in the information content of dividendannouncements. This reduces the propensity of firms to pay or increasedividends, since dividends are costly. The decline in the informationcontent of dividend, is partly because of the rise in stockholding byinstitutional investors that are more sophisticated and informed. Ourresults show a decline in the stock price reaction to announcements ofdividend changes since the mid 1970s. Across firms, the price reactionto dividend news is smaller in firms with high institutional holdings.Institutional investors exploit their superior information by buyingbefore dividend increases and selling afterwards. And, firms with highinstitutional holdings are less likely to raise dividends.

Time Series and Cross-sectional Variations of Expected Returns

Title: Time Series and Cross-sectional Variations of Expected Returns

Dai, Qiang

Abstract: The paper develops a general equilibrium stochastic growth model of amulti-sector economy subject to i.i.d. taste shocks. Each sectorproduces one good, and each firm has a linear production technology andfaces a quadratic capital adjustment cost. The model contains a standardintertemporal capital asset pricing theory of consumption and portfoliodemands with dynamically complete and frictionless markets and astandard q-theory of investment under uncertainty. We show that theequilibrium stochastic investment opportunity set is driven by therelative shares of firms' nominal capital stocks, and the equilibriumdynamics of the state vector is driven by firms' relative investmentintensities. Key implications of the model includes (i) the expectedequity returns are endogenously predictable both over time and in thecross-section; and (ii) the "value anomaly" arises in arational expectations equilibrium due to a negative (positive) hedgingdemand for value (growth) stocks against the risk of cross-sectionaldispersion of firms' nominal capital stocks.

Optimum Centralized Portfolio Construction with Decentralized Portfolio Management

Title: Optimum Centralized Portfolio Construction with Decentralized Portfolio Management

Elton, Edwin J.; Gruber, Martin J.

Abstract: Many financial institutions employ outside portfolio managers to managepart or all of their investable assets. These institutions includepension funds, private endowments (e.g., colleges and charities), andprivate trusts. In 1999, the investment company institute estimated thatthese institutions managed 5.2 trillion dollars in assets. Most of theseinstitutions employed outside managers to invest these funds. Therelevancy of this problem has been widely recognized in thepractitioners literature on portfolio. Furthermore, it is recognized inthe prudent man law that spells out the responsibilities of thecentralized decision maker delegating management responsibility.2 Forexample the New York State law in estate power and trust states. Pensionfunds are the largest and most likely organizations to employ severaloutside managers, each of whom manages a part of the overall portfolio.In this paper we will use the pension fund manager as the prototype ofthe centralized decision-maker trying to optimally manage a set ofdecentralized portfolio managers but the analysts is general.

Are Investors Rational? Choices Among Index Funds

Title: Are Investors Rational? Choices Among Index Funds

Elton, Edwin J.; Gruber, Martin J.; Busse, Jeffrey A.

Abstract: Financial theory is often based on the belief that the actions ofrational investors determine prices, which leads to the elimination ofdominated financial instruments. Recently a series of articles have beenpublished which question the rationality of investor behavior. Standardand Poor’s 500 index funds represent one of the simplest vehiclesfor examining whether investors make rational decisions consistent withthe normal paradigm of financial economics. S&P 500 index funds holdvirtually the same securities, yet they differ by more than two percentper year in the fees they charge investors and the returns they offerinvestors. In this paper, we show that the relative returns offered byalternative S&P index funds are easily predictable. We show that theother important aspects of performance, risk and tax efficiency, arealso easily predictable. Despite this predictability, the relationshipbetween new cash flows and performance is much weaker than we wouldexpect based on rational behavior. Marketing and spillover account forsome, but only a small amount, of the cash flows not accounted for byperformance. We show that selecting funds based on low expenses or highpast returns leads to a portfolio that outperforms the portfolio ofindex funds selected by investors. Our results exemplify the fact that,in a market where arbitrage is not possible, dominated products can prosper.

Do Asset Prices Reflect Fundamentals? Freshly Squeezed Evidence from the FCOJ Market

Title: Do Asset Prices Reflect Fundamentals? Freshly Squeezed Evidence from theFCOJ Market

Boudoukh, Jacob; Richardson, Matthew; Shen, YuQing; Whitelaw, Robert F.

Abstract: This paper reexamines frozen concentrated orange juice (FCOJ) futuresreturns as they relate to fundamentals, in particular, temperature. Weshow that when theory clearly identities the fundamental, i.e., attemperatures close to or below freezing, there is a close link betweenFCOJ prices and that fundamental. Using a simple theoretical nonlinearmodel of the relation between FCOJ returns and temperature, we canexplain approximately 50%of the return variation. This is importantbecause while only 4.5%of the days in winter coincide with freezingtemperatures, two- thirds of the entire winter return variability occurson these days. Moreover, when theory suggests no such relation, i.e., atmost temperature levels, we show empirically that none exists. The factthat there is no relation the majority of the time is good news for thetheory and market efficiency, not bad news. In terms of other FCOJreturn volatility, we also show that other fundamental information aboutsupply, such as USDA production forecasts and news about Brazilproduction, generate significant return variation that is consistentwith theoretical predictions. The evidence in this paper suggests thatthe literature ’s conclusion about irrationality drawn from theFCOJ market have more to do with econometricians ’lack of modelingability than with the empirical facts.

Fees on Fees in Funds of Funds

Title: Fees on Fees in Funds of Funds

Brown, Stephen J.; Goetzmann, William N.; Liang, Bing

Abstract: Funds of funds are an increasingly popular avenue for hedge fundinvestment. Despite the increasing interest in hedge funds as analternative asset class, the high degree of fund specific risk and thelack of transparency may give fiduciaries pause. In addition, many ofthe most attractive hedge funds are closed to new investment. Funds offunds resolve these issues by providing investors with diversificationacross manager styles and professional oversight of fund operations thatcan provide the necessary degree of due diligence. In addition, manysuch funds hold shares in hedge funds otherwise closed to new investmentallowing smaller investors access to the most sought-after managers.However, the diversification, oversight and access comes at the cost ofa multiplication of the fees paid by the investor. It is not generallyunderstood that the incentive fee component of the fee on feearrangement may under certain circumstances exceed the realized returnon the fund. In this paper we argue that the disappointing after feeperformance of some fund of funds may be explained by the nature of thisfee arrangement. We examine an alternative fee arrangement that mayprovide better incentives at a lower cost to investors in these funds.

An Analysis of the Relative Performance of Japanese and Foreign Money Management

Title: An Analysis of the Relative Performance of Japanese and Foreign Money Management

Brown, Stephen J.; Goetzmann, William N.; Hiraki, Takato; Shiraishi, Noriyoshi

Abstract: Foreign investment management firms have recently started to play amajor role in the investment trust business in Japan. In terms of assetsunder management, their size and market share have almost doubled in thepast several years. In part, the relative success of foreign managedfirms in attracting market share may be attributed to the fact thatJapanese investment trusts have underperformed benchmarks in quite adramatic fashion over the past two decades. This is at best indirectevidence that Japanese funds underperform their foreign counterparts. Ina recent paper (Brown, Goetzmann, Hiraki, Otsuki and Shiraishi 2001) weshow that the underperformance can be attributed almost entirely to theunique tax environment of Japanese investment trusts, which had theeffect of heavily penalizing early withdrawals. The relaxation of theseregulations coincided with a major inflow of new money into theinvestment trust business. We examine the relative performance ofJapanese and foreign investment management firms before and after thischange in tax regulations, and find that the poor relative performanceof Japanese funds from April 2000 through December 2001 may in part beattributed to the huge inflow of new money into this sector and thestyle shifts made necessary to accommodate this flow.

Expected Returns and Expected Dividend Growth

Title: Expected Returns and Expected Dividend Growth

Lettau, Martin; Ludvigson, Sydney C.

Abstract: We develop a consumption-based present value relation that is a functionof future dividend growth. Using data on aggregate consumption andmeasures of the dividend payments from aggregate wealth, we show thatchanging forecasts of dividend growth make an important contribution tofluctuations in the U.S. stock market, despite the failure of thedividend-price ratio to uncover such variation. In addition, thesedividend forecasts are found to covary with changing forecasts of excessstock returns. The variation in expected dividend growth we uncover ispositively correlated with "business cycle" variation inexpected returns, and the results suggest that a substantial fraction ofthe variation in expected dividend growth is common to variation inexpected excess returns. Movements in expected dividend growth that areentirely common to movements in expected returns have no effect on thelog dividend-price ratio. An implication of these findings is that thelog dividend-price ratio will have difficulty predicting both dividendgrowth and excess returns at business cycle frequencies. Such a failureof predictive power is not an indication that risk-premia are constant,however. On the contrary, the results presented here imply that the logdividend-price ratio will have difficulty revealing business cyclevariation in both the equity risk-premium and expected dividend growthprecisely because expected returns fluctuate at those frequencies, andcovary with changing forecasts of dividend growth. The findings implythat both the market risk-premium and expected dividend growth varyconsiderably more than what can be revealed using the log dividend-priceratio alone as a predictive variable.

On the Nature of Trading: Do Speculators Leave Footprints?

Title: On the Nature of Trading: Do Speculators Leave Footprints?

Silber, William L.

Abstract: The paper describes how two types of traders, marketmakers andspeculators, establish their positions and manage their risk exposure.We show that balance sheets are insufficient to determine whether atrader is a marketmaker or a speculator. On the other hand, tradingrecords describing the evolution of a position over time can identifywhat trading strategy was pursued. Knowing the trading strategy helps toevaluate contract compliance, risk exposure, and capital requirements oftrading firms. Understanding and verifying trader behavior is especiallyimportant because leveraged trading firms, and individual traders, havetraditional incentives to mask their risk-taking activities. Withoutproper monitoring, traders can substitute risky speculation for lessrisky marketmaking to reap potential payoffs.

Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows

Title: Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows

Brown, Stephen J.; Goetzmann, William N.; Hiraki, Takato; Shiraishi, Noriyoshi; Watanabe, Masahiro

Abstract: We find evidence that is consistent with the hypothesis that dailymutual fund flows may be instruments for investor sentiment about thestock market. We use this finding to construct a new index of investorsentiment, and validate this index using data from both the UnitedStates and Japan. In both markets exposure to this factor is priced, andin the Japanese case, we document evidence of negative correlationsbetween “Bull” and “Bear” domestic funds. Theflows to bear foreign funds in Japan display some evidence of negativecorrelation to domestic and foreign equity funds, suggesting that thereis a foreign vs. domestic sentiment factor in Japan that does not appearin the contemporaneous U.S. data. By contrast, U.S. mutual fundinvestors appear to regard domestic and foreign equity mutual funds aseconomic substitutes.

Delegated Monitoring of Fund Managers

Title: Delegated Monitoring of Fund Managers

Gervais, Simon; Lynch, Anthony W.; Musto, David K.

Abstract: Because a money manager learns more about her skill from her managementexperience than outsiders can learn from her realized returns, sheexpects inefficiency in future contracts that condition exclusively onrealized returns. A fund family that learns what the manager learns canreduce this inefficiency cost if the family is large enough. Thefamily’s incentive is to retain any given manager regardless ofher skill but, when the family has enough managers, it adds value byboosting the credibility of its retentions through the firing of others.In this way, large fund families add value through crosSC-sectionalreputation. As the number of managers grows the efficiency loss goes to zero.

Optimum Centralized Portfolio Construction with Decentralized Portfolio Management

Title: Optimum Centralized Portfolio Construction with Decentralized Portfolio Management

Elton, Edwin J.; Gruber, Martin J.

Abstract: Many financial institutions employ outside portfolio managers to managepart or all of their investable assets. These institutions includepension funds, private endowments (e.g., colleges and charities), andprivate trusts. Pension funds are the largest and most likelyorganizations to employ several outside managers, each of whom manages apart of the overall portfolio. In this paper we will use the pensionfund manager as the prototype of the centralized decision-maker tryingto optimally manage a set of decentralized decision-makers but theanalysts is general. If the centralized decision-maker (CDM) is a meanvariance maximizer, the CDM could construct a portfolio using standardportfolio theory and estimates of mean return, variances, andcovariances between the portfolios constructed by a group ofdecentralized managers. However, this overall portfolio is unlikely tobe optimum since the individually managed portfolios themselves wereconstructed without taking into account the portfolios of the othermanagers. The purpose of this article is to set up a structure thatleads to the optimum portfolio from the viewpoint of the CDM when thereare multiple managers and their portfolios are constructed withoutreference to each other.

Portfolio and Consumption Decisions under Mean-Revering Returns: An Exact Solution for Complete Markets

Title: Portfolio and Consumption Decisions under Mean-Revering Returns: AnExact Solution for Complete Markets

Wachter, Jessica A.

Abstract: This paper solves, in closed form, the optimal portfolio choice problemfor an investor with utility over consumption under mean-revertingreturns. Previous solutions either require approximations, numericalmethods, or the assumption that the investor does not consume over hislifetime. This paper breaks the impasse by assuming that markets arecomplete. The solution leads to a new understanding of hedging demandand of the behavior of the approximate log-linear solution. Theportfolio allocation takes the form of a weighted average and is shownto be analogous to duration for coupon bonds. Through this analogy, thenotion of investment horizon is extended to that of an investor whoconsumes at multiple points in time.

A First Look at the Accuracy of the CRSP Mutual Fund Database and a Comparison of the CRSP and Morningstar Mutual Fund Databases

Title: A First Look at the Accuracy of the CRSP Mutual Fund Database and aComparison of the CRSP and Morningstar Mutual Fund Databases

Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R.

Abstract: This paper examines problems in the CRSP Survivor Bias Free U.S. MutualFund Database (CRSP, 1998) and compares returns contained in it to thosein Morningstar. The CRSP database has an omission bias that has the sameeffects as survivorship bias. Although all mutual funds are listed inCRSP, return data is missing for many and the characteristics of thesefunds differ from the populations. The CRSP return data is biased upwardand merger months are inaccurately recorded about half the time.Differences in returns in Morningstar and CRSP are a problem for olderdata and small funds.

Spiders: Where are the Bugs?

Title: Spiders: Where are the Bugs?

Elton, Edwin J.; Gruber, Martin J.; Comer, George; Li, Kai

Incentive Fees and Mutual Funds

Title: Incentive Fees and Mutual Funds

Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R.

Abstract: The purpose of this article is to examine the impact of incentive feeson mutual fund performance. The paper proceeds as follows. In the firstsection we examine the characteristics and the use of incentive fees inthe mutual fund industry. In the second section we explore the theory ofthe effect of incentive fees on manager behavior. In the third sectionwe discuss our data. In the fourth section we examine empirical resultsconcerning fees earned, risk-adjusted performance, the effect ofincentive fees on risk, and new cash flows into funds using incentive fees.

Asset Pricing in a Neoclassical Model with Limited Participation

Title: Asset Pricing in a Neoclassical Model with Limited Participation

Dai, Qiang

Abstract: In this paper, I show that habit formation is perhaps not what it iscommonly perceived to be: an extension of preference specification forthe representative agent. Rather, it captures a dynamic interactionbetween aggregate financial income and aggregate labor income. I alsoshow that existing specifications of consumption habit can be extendedto incorporate a stochastic shock, which is interpreted as the laborincome shock. As a result of these two innovations, I show that a habitformation model can explain the equity premium, equity volatility, andrisk free rate puzzles simultaneously, and provide an equilibriumjustification for the predictability of equity and bond returns bydividend/pride ration and term spreads - all in terms of observablesample moments of aggregate dividend income and labor income growthrates and reasonable values of risk aversion coefficient and thesubjective discount rate. To substantiate these claims, I present anextension of the Breeden-Lucas CCAPM by incorporating a particular formof heterogeneity assumption and a particular form of limitedparticipation assumption. The resulting model features a richertechnological specification (from the perspective of a productioneconomy) or a richer standard assumptions of constant relative riskaversion, complete markets, and frictionless trading from theperspective of the marginal investor.

DotCom Mania: The Rise and Fall of Internet Stock Prices

Title: DotCom Mania: The Rise and Fall of Internet Stock Prices

Ofek, Eli; Richardson, Matthew

Abstract: This paper provides one potential explanation for the rise, persistenceand eventual fall of internet stock prices. Specifically, we appeal to amodel of heterogenous agents with varying degrees of beliefs about assetpayoffs who are subject to short sales constraints. In this framework,it is possible that “optimistic” investors overwhelm“pessimistic” ones, leading to prices not reflectingfundamental values about cash flows summarized by aggregate beliefs.Empirical support for this explanation is provided by exploring thebehavior of internet stock prices during the period January 1998 toNovember 2000. In particular, we document four important elements to ourstory: (i) the high level of internet stock prices given theirunderlying fundamentals, (ii) responses of stock prices to a shifttowards potentially optimistic investors, (iii) empirical resultsconsistent with shorting being at its maximum possible level forinternet stocks, and (iv) the eventual fall, or bubble bursting, ofinternet stocks being tied to the increase in the number of sellers tothe market via expiration of lockup agreements.

Habit Formation and Returns on Bonds and Stocks

Title: Habit Formation and Returns on Bonds and Stocks

Wachter, Jessica A.

Abstract: This paper proposes a habit formation model that explains the failure ofthe expectations hypothesis documented by Campbell and Shiller (1991)and Fama and Bliss (1987). The model also produces positive excessreturns on long-term bonds, an upward sloping average yield curve, andallows for realistic levels of time-variation in the mean of consumptiongrowth. The model generates a novel empirical prediction: Long lags ofconsumption growth predict the short-term interest rate with a negativesign. This prediction is shown to be strongly supported by the data.

An Analysis of the Relative Performance of Japanese and Foreign Money Management

Title: An Analysis of the Relative Performance of Japanese and Foreign Money Management

Brown, Stephen J.; Goetzmann, William N.; Hiraki, Takato; Shiraishi, Noriyoshi

Abstract: Foreign investment management firms have recently started to play amajor role in the investment trust business in Japan. In terms of assetsunder management, their size and market share have almost doubled in thepast two years. In part, the relative success of foreign managed firmsin attracting market share may be attributed to the fact that Japaneseinvestment trusts have underperformed benchmarks in quite a dramaticfashion over the past two decades. This is at best indirect evidencethat Japanese funds underperform their foreign counterparts. In a recentpaper (Brown, Goetzmann, Hiraki, Otsuki and Shiraishi 2001) we show thatthe underperformance can be attributed almost entirely to the unique taxenvironment of Japanese investment trusts. In this paper we examine therelative performance issue directly by looking at week by week returnsfor the period January 23, 1998 through to January 14, 2000. Contrary topopular perception, Japanese managers actually outperformed theirforeign counterparts over this period of time. Perhaps this indicatesthat Japanese managers are more skillful. However, the evidence suggeststhat they happened to be in the right place at the right time. Weattribute the superior performance to the asset allocation decision,rather than to any superior skill in selecting securities.

Risk Management with Benchmarking

Title: Risk Management with Benchmarking

Basak, Suleyman

Abstract: Portfolio theory must address the fact that in reality, portfoliomanagers are evaluated relative to a benchmark, and therefore adopt riskmanagement practices to account for the benchmark performance. Wecapture this risk management consideration by allowing a prespecifiedshortfall from a target benchmark-linked return, consistent with growinginterest in such practice. In a dynamic setting, we demonstrate how arisk averse portfolio manager optimally under- or overperforms a targetbenchmark under different economic conditions, depending on his attitudetowards risk and choice of the benchmark. Investors can thereforeachieve their desired gain/loss characteristics for funds undermanagement through an appropriate combined choice of the benchmark andmoney manager.

Illiquidity and Stock Returns: Cross-Section and Time-Series Effects

Title: Illiquidity and Stock Returns: Cross-Section and Time-Series Effects

Amihud, Yakov

Abstract: New tests are presented on the effects of stock illiquidity on stockreturn. Over time, expected market illiquidity positively affects exante stock excess return (usually called “risk premium”).This complements the positive cross-sectional return-illiquidityrelationship. The illiquidity measure here is the average daily ratio ofabsolute stock return to dollar volume, which is easily obtained fromdaily stock data for long time series in most stock markets. Illiquidityaffects more strongly small firms stocks, suggesting an explanation forthe changes “small firm effect” over time. The impact ofmarket illiquidity on stock excess return suggests the existence ofilliquidity premium and helps explain the equity premium puzzle.

Portfolio Choice with Many Risky Assets, Market Clearing and Cash Flow Predictability

Title: Portfolio Choice with Many Risky Assets, Market Clearing and Cash Flow Predictability

Lynch, Anthony W.

Abstract: This paper examines portfolio allocations and market clearing priceswhen the representative agent can allocate across equity portfoliosformed on the basis of characteristics like size and book-to- market andportfolio cash flows are predictable. The state space is discrete andprice-consumption ratios are obtained portfolio by portfolio simply byinverting an economy-wide matrix and multiplying this matrix by aportfolio-specific vector. The economy-wide matrix has thedimensionality of the state space. The paper calibrates cash flowpredictability to the data using the consumption-wealth fraction (cay)of Lettau and Ludvigson (2000a) and dividend yield (div) as statevariables. Annual cash flow processes are calibrated for three stockportfolios and for the aggregate consumption stream. The economy'srepresentative agent possesses a relative risk aversion coefficient ofeither 5 or 10. When cash flow predictability is calibrated to the datausing cay as the predictor and risk aversion is 5, equilibrium excessreturns on the four assets are more volatile, more correlated with eachother, and have higher means than in the equivalent economy with i.i.d.cash flows. Further, the conditional second moments for returns and thecontemporaneous state variable are found to be highly state-dependent.The paper finds much smaller excess return predictability using cay inthe calibrated economy than in the data, though the relation is positivein both. Conditional Sharpe ratios are virtually invariant to state.While the representative agent's optimal portfolio is not verystate-dependent, her hedging demands are quite large and her optimalportfolio is not minimum-variance. For example, her single-periodallocation to the four risky assets is about 75% of the portfolio whileher infinite-horizon allocation is 100%. The implication is that theconditional CAPM does not hold in the conditional economy with cay asthe state variable. However, the spread in CAPM abnormal returns acrossthe three book-to-market portfolios is an order of magnitude smaller inthe calibrated economies than in the data. The spread in the data in5.6% p.a. while the largest spread in the six calibrated economiesconsidered is only 0.6% p.a. Finally, the paper has importantimplications for partial equilibrium analyses of dynamic portfolio choice.

Mutual Fund Survivorship

Title: Mutual Fund Survivorship

Carhart, Mark M.; Carpenter, Jennifer N.; Lynch, Anthony W.; Musto, David K.

Abstract: This paper offers a comprehensive study of survivorship issues, in thecontext of mutual fund research, using the mutual fund data set ofCarhart (1997). We find that funds in our sample disappear primarilybecause of multi-year poor performance. Then we demonstrate analyticallythat this survival rule typically causes the survivor bias in averageperformance to increase in the length of the sample period, though it ispossible to construct counterexamples. In the data, we find a strongpositive relation between the survivor bias in average performance andsample period length. The bias is economically small at 17 basis pointsper annum for one-year samples, but a significantly larger one percentper annum for samples longer than fifteen years. We also find evidenceof performance persistence in our sample and, consistent with thepresence of a multi-period survival rule, we find that the persistenceis weakened by survivorship bias. Finally, we explain how the relationbetween performance and fund characteristics can be affected by the useof a survivor-only sample and show that the magnitudes of the biases inthe slope coefficients are large for fund size, expenses, turnover andload fees in our sample. Because survivorship issues are relevant formany data sets used in finance, the analysis in this paper has potentialapplications in areas of financial economics beyond just mutual fund research.

Optimal Consumption and Portfolio Allocation under Mean-Reverting Returns: An Exact Solution for Complete Markets

Title: Optimal Consumption and Portfolio Allocation under Mean-RevertingReturns: An Exact Solution for Complete Markets

Wachter, Jessica A.

Abstract: This paper solves, in closed form, the optimal portfolio choice problemfor an investor with utility over consumption under mean-revertingreturns. Previous solutions either require approximations, numericalmethods, or the assumption that the investor does not consume over hislifetime. This paper breaks the impasse by assuming that markets arecomplete. The solution leads to a new understanding of hedging demandand the behavior of approximate log-linear solutions. The portfolioallocation takes the form of a weighted average and is shown to beanalogous to duration for coupon bonds. Through this analogy, the notionof investment horizon is extended to that of an investor who consumes atmultiple points in time.

Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry

Title: Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry

Brown, Stephen J.; Goetzmann, William N.; Park, James

Abstract: Investors in hedge funds and commodity trading advisors [CTA’s]are naturally concerned with risk as well as return. In this paper, weinvestigate risk of hedge funds and CTA’s in light of managerialcareer concerns. We find an association between past performance andrisk levels consistent with Brown, Harlow and Starks (1996) findings formutual fund managers. Good performers in the first half of the yearreduce the volatility of their portfolios, and poor performers increasevolatility. These “variance strategies" depend upon thefund’s ranking relative to other funds. The importance of relativerankings as opposed to the absolute ranking suggested by analysis ofhedge fund and CTA manager contracts points to the importance ofreputation costs. These costs are best thought of in the context of thecareer concerns of managers and the relative importance of fundtermination. We analyze factors contributing to fund disappearance.Survival depends on both absolute and relative performance. Excessvolatility can also lead to termination. Finally, other things equal,the younger a fund, the more likely it is to disappear from the sample.Therefore our results strongly confirm an hypothesis of Fung and Hsieh(1997b) that reputation costs have a mitigating effect on the gamblingincentives implied by the manager contract. Particularly for youngfunds, a volatility strategy that increases the value of a performancefee option may lead to the premature death of that option throughtermination of the fund. The finding that hedge fund and CTA volatilityis conditional upon past performance has implications for investors,lenders and regulators. An important result of our finding is thatvariance strategy depends upon relative rather than absolute performance evaluation.

Risk and Return: Some New Evidence

Title: Risk and Return: Some New Evidence

Guo, Hui; Whitelaw, Robert

Abstract: We develop a structural asset pricing model to investigate therelationship between stock market risk and return. The structural modelis estimated using the conditional market variance implied by S&P100 index option prices. Relative risk aversion is precisely identifiedand is found to be positive, with point estimates ranging from 3.06 to4.01. However, the implied volatility data only spans the periodNovember 1983 to May 1995. As a robustness check, the structural modelis also examined with postwar monthly data, in which the conditionalmarket variance is estimated. We again find a positive and significantrisk-return relation and get similar point estimates for relative riskaversion. Additionally, we document some facts about stock marketreturn. First, stock price movements are primarily driven by changes ininvestment opportunities, not by changes in market volatility. Second,there is some evidence of a leverage effect. Third, relative riskaversion is quite stable over time.

The Last Great Arbitrage: Exploiting the Buy-and-Hold Mutual Fund Investor

Title: The Last Great Arbitrage: Exploiting the Buy-and-Hold Mutual Fund Investor

Boudoukh, Jacob; Richardson, Matthew P.; Subrahmanyam, Marti

Abstract: This paper demonstrates that an an institutional feature inherent in amultitude of mutual funds managing billions in assets generates fundNAVs that reflect stale prices. Since, in many cases, investors cantrade at these NAVs with little or no transactions costs, there is anobvious trading opportunity. Simple, feasible strategies generate Sharperatios that are sometimes one hundred times greater than the Sharperatio of the underlying fund. These opportunities are especiallyprevalent in international funds that buy Japanese or European equitiesand in funds that invest in thinly traded securities in the U.S. Whenimplemented, the gains from these strategies are matched by o settinglosses incurred by buy-and-hold investors in these funds. In oneparticular example, we explore the consequences of trading betweendifferent Vanguard mutual funds, motivated via the rules inherent inUniversity 403B plans. Compared to an equal-weighted buy-and-holdportfolio of international Vanguard funds with a 25% cumulative return,the strategy discussed in this paper produces a 139% return while beingin the stock market less than 25% of the time!

Ownership Structure, Income Distribution, and Competitive Equilibrium: A Theory of Business Cycles, Human Capital, and Asset Returns

Title: Ownership Structure, Income Distribution, and Competitive Equilibrium: ATheory of Business Cycles, Human Capital, and Asset Returns

Dai, Qiang

Abstract: In this paper, I present a theory of dynamic economic growth, businesscycles, and asset pricing that integrates (1) Marx's idea (andemphasized by Klein) of a two-class heterogeneity of the ownershipstructure of physical capital and human capital in a capitalist society,(2) Keynes' idea of sticky wages, and (3) the existence of a competitiveequilibrium with intertemporal consumption and portfolio decisions byrisk-averse capitalists facing a contractual labor cost. The aggregatelabor income as a function of recent history of aggregate outputs isdetermined by the prevailing mode of income distribution. I focus on amodern capitalist economy in which the income distribution is notdictated by the capitalists (as in the formative years of capitalismwhich was the subject of inquiry by Adam Smith, David Ricardo, and KarlMax), but rather is determined by the economic and political consensusreached between the capitalists and workers through a legal andpolitical framework featuring strong labor unions, anti-trust laws, andprogressive tax codes. Three main implications for the macro-economyare presented. First, my theory endogenizes completely thethree-equation Klein model of consumption function, savings function,and the wage demand function. Second, I show that cyclic behavior isdriven entirely by the assumed form of income distribution. Productionand labor income shocks do not drive, but help sustain the cyclicbehavior by preventing the economy from converging to the steady statemean. Third, I show that the Marxian doctrine that the "rate ofsurplus value" remains constant and the "organic compositionof capital" keeps rising is inconsistent with the predictions of mymodel, and the difference is traced to the different assumptions onincome distribution, and leads to different conclusions on the stabilityof capitalist economies. By assuming that capital markets clear inequilibrium, I determine the risk premium for both production and laborincome risks, and consequently asset returns and the value of humancapital - all endogenously. A special case of the model isobservationally equivalent to the stochastic habit formation model ofDai (2000), and thus inherits its ability to simultaneously explain theequity premium puzzle, riskless rate puzzle, and the expectationspuzzle. In general, the labor market need not clear, due to the onlyfriction in the model: the longevity of the labor contract.

From Equity Premium Puzzle to Expectations Puzzle: General Equilibrium Production Economy with Stochastic Habit Formation

Title: From Equity Premium Puzzle to Expectations Puzzle: General EquilibriumProduction Economy with Stochastic Habit Formation

Dai, Qiang

Abstract: This paper develops a general equilibrium model for a representativeagent, production economy with stochastic internal habit formation. Themodel describes a scale-independent economy, with a unique stochasticinvestment opportunity set. Local correlation between the stochasticinterest rate and time-varying market price of risk can be determinedendogenously and leads to correct predictions on the sign and magnitudeof several major empirical puzzles in both equity and bond markets. Inthe empirical part of the paper, we calibrate our model, simultaneously,to the equity premium puzzle, the risk-free rate puzzle, and theexpectations puzzle, and show that the three puzzles are completelyresolved under reasonable parameter values. Thus, we establish,conclusively, the inextricable link between the equity and bond markets,both theoretically and empirically. Our model subsumes the internalhabit formation models of Sundaresan (1989) and Constantinides (1990),and, perhaps somewhat surprisingly, the external habit formation modelof Campbell and Cochrane (1999).

Expectation Puzzles, Time-varying Risk Premia, and Dynamic Models of the Term Structure

Title: Expectation Puzzles, Time-varying Risk Premia, and Dynamic Models of theTerm Structure

Dai, Qiang; Singleton, Kenneth

Abstract: Though linear projections of returns on the slope of the yield curvehave contradicted the implications of the traditional "expectationstheory," we show that these findings are not puzzling relative to alarge class of richer dynamic terms structure models. Specifically, weare able to match all of the key empirical findings reported by Fama andBliss and Campbell and Shiller, among others, within large subclasses ofaffine and quadractic-Gaussian term structure models. Key to thismatching are parameterizations of the market prices of risk that let usseparately "control" the shape of the mean yield curve and thecorrelation structure of excess returns with the slope of the yieldcurve. The risk premiums have a simple form consistent with Fama'sfindings on the predictability of forward rates, and are shown to alsobe consistent with interest rate, feedback rules used by a monetaryauthority in setting monetary policy.

Portfolio Performance and Agency

Title: Portfolio Performance and Agency

Dybvig, Philip H.; Farnsworth, Heber K.; Carpenter, Jennifer

Abstract: The evaluation and compensation of portfolio managers is an importantproblem for practitioners. Optimal compensation will induce managers toexpend effort to generate information and to use it appropriately in aninformed portfolio choice. Our general model points the way towardsanalysis of optimal performance evaluation and contracting in a richmodel. Optimal contracting in the model includes an important role forportfolio restrictions that are more complex than the sharing rule. Theagent's compensation gives the agent approximately to benchmark returnplus an incentive fee equal to a portfolio measure that is approximatelythe excess of return above the benchmark. This measure is often used bypractitioners but is simpler than the Jensen measure and other measurescommonly recommended in the academic literature. In addition to theexcess return above the fixed benchmark, the manager is given someadditional incentive to take a position that deviates from the benchmarkto remove an incentive to tend towards being a "closetindexer." Efficient contracting involves restrictions on whatportfolio strategies can be pursued, and prior communication of theinformation gathered.

The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly

Title: The Information in Long-Maturity Forward Rates: Implications forExchange Rates and the Forward Premium Anomaly

Boudoukh, Jacob; Richardson, Matthew; Whitelaw, Robert F.

Abstract: The forward premium anomaly is one of the most robust puzzles infinancial economics. We recast the underlying parity relation in termsof cross-country differences between forward interest rates rather thanspot interest rates with dramatic results. These forward interest ratedifferentials have statistically and economically significant forecastpower for annual exchange rate movements, both in- and out-of-sample,and the signs and magnitudes of the corresponding coefficients areconsistent with economic theory. Forward interest rates also forecastfuture spot interest rates and future inflation. Thus, we attribute muchof the forward premium anomaly to the anomalous behavior of shortterminterest rates, not to a breakdown of the link between fundamentals andexchange rates.

The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly

Portfolio Choice and Equity Characteristics: Characterizing the Hedging Demands Induced by Return Predictability

Title: Portfolio Choice and Equity Characteristics: Characterizing the HedgingDemands Induced by Return Predictability

Lynch, Anthony W.

Abstract: This paper examines portfolio allocation across equity portfolios formedon the basis of characteristics like size and book-to- market. Inparticular, the paper assesses the impact of return predictability onportfolio choice for a multi-period investor with a coefficient ofrelative risk aversion of 4. Compared to the investor’s allocationin her last period, return predictability with dividend yield causes theinvestor early in life to tilt her risky-asset portfolio away from highbook-to-market stocks and away from small stocks. These results areexplained using Merton’s (1973) characterization of portfolioallocation by a multiperiod investor in a continuous time setting.Abnormal returns relative to the investor’s optimal early-lifeportfolio are also calculated. These abnormal returns are found toexhibit the same cross-sectional patterns as abnormal returns calculatedrelative to the market portfolio: higher for small than large firms, andhigher for high than low book-to-market firms. Thus, hedging demand maybe a partial explanation for the high expected returns documentedempirically for small firms and high book-to-market firms. However, evenwith this hedging demand, the investor wants to short-sell the lowbook-to market portfolio to hold the high book-to-market portfolio. Theutility costs of using a value-weighted equity index or of ignoringpredictability are also calculated. An investor using a value-weightedequity index would give up a much larger fraction of her wealth to haveaccess to book-to-market portfolios than size portfolios. Finally, whilean investor would give up a much larger fraction of her wealth to haveaccess to dividend yield information than term spread information, termspread does have incremental benefits over and above just using dividendyield alone.

Regime Shifts and Bond Returns

Title: Regime Shifts and Bond Returns

Boudoukh, Jacob; Richardson, Matthew; Smith, Tom; Whitelaw, Robert

Abstract: This paper investigates the implications of a 2-regime model of thebusiness cycle for term premiums and volatilities in the bond market.The model, which is estimated via maximum likelihood using GDP,consumption and production data, has two key features -- mean growthrates that vary across regimes and time-varying transition probabilitiesbetween regimes. The implied dynamics of term premiums and volatilitiesare complex and interesting. Business cycle turning points arecharacterized by high volatility and strongly time-varying termpremiums. These implications are then investigated using data on bondreturns. Nonparametric estimation results are broadly consistent withthe model. Using the slope of the term structure as a conditioningvariable, we can identify periods with negative term premiums andvolatile returns.

The Investor Recognition Hypothesis in a Dynamic General Equilibrium: Theory and Evidence

Title: The Investor Recognition Hypothesis in a Dynamic General Equilibrium:Theory and Evidence

Shapiro, Alexander

Abstract: This paper analyzes equilibrium in a dynamic pure-exchange economy undera generalization of Merton's (1987) investor recognition hypothesis(IRH). Because of information costs, a class of investors is assumed topossess incomplete information, which suffices to implement only aparticular trading strategy. The IRH is mapped into correspondingportfolio restrictions that bind a subset of agents. The model isformulated in continuous time, and detailed characterization ofequilibrium quantities is provided. The model implies that, all elseequal, a risk premium on a less visible stock need not be higher thanthat on a more visible stock with a lower volatility -- contrary toresults derived in a static mean-variance setting. An empirical analysissuggests that a consumption-based capital asset pricing model (CCAPM)augmented by the IRH is a more realistic model than the traditionalCCAPM for explaining the cross-sectional variation in unconditionalexpected equity returns.

Multivariate Stock Returns Around Extreme Events: A Reassessment of Economic Fundamentals and the 1987 Market Crash

Title: Multivariate Stock Returns Around Extreme Events: A Reassessment ofEconomic Fundamentals and the 1987 Market Crash

Fisher, Adlai

Abstract: This paper reassesses the role of economic fundamentals in the 1987stock market crash using a two factor common-component model of returns.The model decomposes returns into idiosyncratic components, a commonwhite noise component, and a common source of Poisson jumps. Among threetwo-year sample periods for Major Market Index stocks, only a 1987-88sample results in an estimated jump component with low frequency andlarge size. Using Bayes' rule, we infer ex post jump probabilities foreach sample day. In contrast to an analogous univariate model for anindex return, the multivariate model captures information in thecross-section of returns. Leading financial news on the most likely jumpdays from the multivariate model is compared with news on a controlgroup of high index return days. Days with high jump probabilities underthe multivariate model contain systematically more news related to thedollar, trade deficits, and financing of the U. S. budget deficit. Thissuggest that the common jump component proxies for economic fundamentsrelated to this cluster of news events, and that the unexpectedly largeU.S. trade deficit news released on the Wednesday prior to the crashprovided an economic catalyst for the event.

Financial Markets and Firm Dynamics

Title: Financial Markets and Firm Dynamics

Cooley, Thomas F.; Quadrini, Vincenzo

Abstract: Recent studies have shown that the dynamics of firms (growth, jobrelocation and exit) are negatively associated with the firm's size. Inthis paper we analyze whether financial factors are important ingenerating this negative relation. We develop a model in which, at eachpoint in time, firms are heterogeneous in the amount of equity, and theequity affects their financing decision. The production and investmentbehavior of small and large firms differs substantially, and the modelreplicates many of the key features of industry evolution: smaller firmsexperience faster growth, higher rates of job creation and destructionand lower survival rates.

Political Risk, Financial Crisis, and Market Volatility

Title: Political Risk, Financial Crisis, and Market Volatility

Mei, Jianping (J.P.)

Abstract: This paper examines the impact of political uncertainty on the recentfinancial crises in emerging markets. By examining political electioncycles, we find that eight out of nine of the recent financial criseshappened during periods of political election and transition. Using acombination of probit and switching regression analysis, we find thatthere is a significant relationship between political election andfinancial crisis after controlling for differences in economic andfinancial conditions. We observe increased market volatility duringpolitical election and transition periods. Moreover, we have someevidence that political risk is more important in explaining financialcrisis than market contagion. Our results suggest that politicaluncertainty could be a major contributing factor to financial crisis.Thus, politics does matter in emerging markets. Since the odds offinancial crisis tend to be much larger during the political electionperiods, institutional investors should take that into account whenmaking emerging market investment during those time periods.

Private Insurance Markets or Redistributive Taxes?

Title: Private Insurance Markets or Redistributive Taxes?

Krueger, Dirk; Perri, Fabrizio

Abstract: We explore the welfare consequences of different taxation schemes in aneconomy where agents are debt-constrained. If agents default on theirdebt, they are banned from future intertemporal trade, but retain theirprivate (labor) endowments which are subject to income taxation. Weimpose individual rationality constraints on agents guaranteeing nodefault in equilibrium and we solve for efficient consumptiondistribution across agents. A change in the tax system changes theseverity of punishment from default. We demonstrate that a change to amore redistributive tax system leads to a restriction of the set ofcontracts that are individually rational and that this restriction leadsto a limitation of possible risk sharing via private contracts. Thewelfare consequences of a change in the tax system depend on therelative magnitudes of increased risk sharing forced by the new taxsystem and the reduced risk sharing in private insurance markets. Wequantitatively address this issue by calibrating an artificial economyto US income and tax data. We show that for a plausible selection of thestructural parameters of our model, the change to a more redistributivetax system leads to less risk sharing among individuals and, hence,lower ex-ante welfare.

Arbitrage And Viability in Securities Markets With Fixed Trading Costs

Title: Arbitrage And Viability in Securities Markets With Fixed Trading Costs

Jouini, Elyes; Kallal, Hedi; Napp, Clotilde

Abstract: This paper studies foundational issues in securities markets models withfixed costs of trading, i.e. transaction costs that are boundedregardless of the transaction size, such as fixed brokerage fees,investment taxes, operational and processing costs, or opportunitycosts. We show that the absence of free lunches in such models isequivalent to the existence of a family of absolutely continuousprobability measures for which the normalized price processes aremartingales, conditional to any possible future event. This is a weakercondition than the absence of free lunches in frictionless models, whichis equivalent to the existence of an equivalent martingale measure. Wealso show that the only arbitrage free pricing rules on the set ofattainable contingent claims are those that are equal to the sum of anexpected value with respect to any absolutely continuous martingalemeasure and of a bounded fixed cost functional. Moreover, these pricingrules are the only ones to be viable as models of economic equilibrium.

Optimal Investment with Taxes: An Existence Result

Title: Optimal Investment with Taxes: An Existence Result

Jouini, Elyès; Koehl, Pierre-Francois; Touzi, Nizar

Abstract: We study the deterministic control problem of maximizing utility fromconsumption of an agent who seeks to optimally allocate his wealthbetween consumption and investment in a financial asset subject to taxeson benefits with first-in-first-out priority rule on sales. Short-salesare prohibited and consumption is restricted to be nonnegative. Such aproblem has been introduced in a previous paper by the same authorswhere the first order conditions have been derived. In this paper, weestablish an existence result for this non-classical optimal control problem.

Liquidity Crises in Emerging Markets: Theory and Policy

Title: Liquidity Crises in Emerging Markets: Theory and Policy

Chang, Roberto; Velasco, Andres

Tax and Education Policy in a Heterogeneous Agent Economy: What Levels of Redistribution Maximize Growth and Efficiency?

Title: Tax and Education Policy in a Heterogeneous Agent Economy: What Levelsof Redistribution Maximize Growth and Efficiency?

Benabou, Roland

Standard Risk Aversion and the Demand for Risky Assets in the Presence of Background Risk

Title: Standard Risk Aversion and the Demand for Risky Assets in the Presenceof Background Risk

Franke, Gunter; Stapleton, Richard C.; Subrahmanyam, Marti G.

Abstract: We consider the demand for state contingent claims in the presence of azero-mean, non-hedgeable background risk. An agent is defined to begeneralized risk averse if he/she reacts to an increase in backgroundrisk by choosing a demand function for contingent claims with a smallerslope. We show that the conditions for standard risk aversion: positive,declining absolute risk aversion and prudence are necessary andsufficient for generalized risk aversion. We also derive a necessary andsufficient condition for the agent's derived risk aversion to increasewith a simple increase in background risk.

The IT Revolution and the Stock Market

Title: The IT Revolution and the Stock Market

Greenwood, Jeremy; Jovanovic, Boyan

Abstract: A new technology or product is often developed by the singleentrepreneur. Whether he reaches the initial public offering stage or isacquired by a listed firm, it takes time for the innovator to add valueto the stock market. Indeed, the innovation may, at first, reduce themarket's value because some firms --- usually large or old --- willcling to old technologies that have lost their momentum. This paperargues that (a) the market declined in the late 1960s because it feltthat the old technologies either had lost their momentum or would giveway to IT, and that (b) IT innovators boosted the stock market's valueonly in the 1980s. If the stock market provides a forecast of futureevents, then the recent dramatic upswing represents a rosy estimateabout growth in future profits for the economy. This translates into aforecast of higher output and productivity growth, holding other thingsequal (such as capital's share of income).

Why Does Capital Structure Choice Vary With Macroeconomic Conditions?

Title: Why Does Capital Structure Choice Vary With Macroeconomic Conditions?

Levy, Amnon

Abstract: This paper develops a calibrated model that explains the pronouncedcounter-cyclical leverage patterns observed for firms that access publiccapital markets, and relates these patters to debt and equity issues.Moreover, it explains why leverage and debt issues do not exhibit thispronounced behavior for firms that face more severe constraints whenaccessing capital markets. In the model, managers issue a combination ofdebt and equity to finance investment by weighing the trade-off betweenagency problems and risk sharing. During contractions, leveragedmanagers receive a relatively small share of wealth, resulting in arelative increase in household demand for securities. Securities marketsclear as managers that are not up against their borrowing constraintsincrease leverage while satisfying the agency condition that theymaintain a large enough portion of their firm’s equity.

Inflation, Financial Development and Growth

Title: Inflation, Financial Development and Growth

Rousseau, Peter L.; Wachtel, Paul

Risk and Return: Some New Evidence

Portfolio Choice with Many Risky Assets, Market Clearing and Cash Flow Predictability

Two Ways to Rule Out the Overconsumption Paths in the Ramsey Model with Irreversible Investment

Title: Two Ways to Rule Out the Overconsumption Paths in the Ramsey Model withIrreversible Investment

Comín, Diego

Abstract: In this note I develop two approaches to rule out the Overconsumptionpaths in the Ramsey model with irreversible capital. The first focuseson the multiplier of the irreversible constraint and is applied to thesituation where preferences are CES and the production function isCobb-Douglas. The second relies on a revealed preference argument andis used to rule out overconsumption paths when the preferences arestrictly concave and the initial level of perspective capital is belowits steady state level.

Optimal Consumption and Portfolio Allocation under Mean-Reverting Returns: An Exact Solution for Complete Markets

Expectation Puzzles, Time-varying Risk Premia, and Dynamic Models of the Term Structure

Financial Constraints and House Prices—An International Perspective

Title: Financial Constraints and House Prices—An International Perspective

Almeida, Heitor

Abstract: In this paper, we show substantial empirical evidence that house pricesare more sensitive to shocks to per-capita income, in countries wherehousing finance is more developed. This result is consistent with thetheoretical framework developed in the paper, where we study the impactof progressive relaxation of financial constraints on housing demand andequilibrium house prices. Our results are consistent with recentliterature on financial constraints and business investment, whichargues that the investment of less constrained firms can be moresensitive to changes in cash flow. More broadly, our results challengethe traditional view that financial development leads to smallerfluctuations in key economic variables. From a policy perspective, ourpaper suggests that even if financial development is desirable for otherreasons, the associated increase in the extent of fluctuations should bean explicit policy concern.

Ownership Structure, Income Distribution, and Competitive Equilibrium: A Theory of Business Cycles, Human Capital, and Asset Returns

Title: Ownership Structure, Income Distribution, and Competitive Equilibrium:A Theory of Business Cycles, Human Capital, and Asset Returns

Dai, Qiang

Abstract: In this paper, I present a theory of dynamic economic growth, businesscycles, and asset pricing that integrates (1) Marx's idea (andemphasized by Klein) of a two-class heterogeneity of the ownershipstructure of physical capital and human capital in a capitalist society,(2) Keynes' idea of sticky wages, and (3) the existence of a competitiveequilibrium with intertemporal consumption and portfolio decisions byrisk-averse capitalists facing a contractual labor cost. The aggregatelabor income as a function of recent history of aggregate outputs isdetermined by the prevailing mode of income distribution. I focus on amodern capitalist economy in which the income distribution is notdictated by the capitalists (as in the formative years of capitalismwhich was the subject of inquiry by Adam Smith, David Ricardo, and KarlMax), but rather is determined by the economic and political consensusreached between the capitalists and workers through a legal andpolitical framework featuring strong labor unions, anti-trust laws, andprogressive tax codes. Three main implications for the macro-economyare presented. First, my theory endogenizes completely thethree-equation Klein model of consumption function, savings function,and the wage demand function. Second, I show that cyclic behavior isdriven entirely by the assumed form of income distribution. Productionand labor income shocks do not drive, but help sustain the cyclicbehavior by preventing the economy from converging to the steady statemean. Third, I show that the Marxian doctrine that the "rate ofsurplus value" remains constant and the "organic compositionof capital" keeps rising is inconsistent with the predictions of mymodel, and the difference is traced to the different assumptions onincome distribution, and leads to different conclusions on the stabilityof capitalist economies. By assuming that capital markets clear inequilibrium, I determine the risk premium for both production and laborincome risks, and consequently asset returns and the value of humancapital - all endogenously. A special case of the model isobservationally equivalent to the stochastic habit formation model ofDai (2000), and thus inherits its ability to simultaneously explain theequity premium puzzle, riskless rate puzzle, and the expectationspuzzle. In general, the labor market need not clear, due to the onlyfriction in the model: the longevity of the labor contract. From EquityPremium Puzzle to Expectations Puzzle: A General Equilibrium ProductionEconomy with Stochastic Habit Formation

From Equity Premium Puzzle to Expectations Puzzle: A General Equilibrium Production Economy with Stochastic Habit Formation

Title: From Equity Premium Puzzle to Expectations Puzzle: A General EquilibriumProduction Economy with Stochastic Habit Formation

Dai, Qiang

Abstract: This paper develops a general equilibrium model for a representativeagent, production economy with stochastic internal habit formation. Themodel describes a scale-independent economy, with a unique stochasticinvestment opportunity set. Local correlation between the stochasticinterest rate and time-varying market price of risk can be determinedendogenously and leads to correct predictions on the sign and magnitudeof several major empirical puzzles in both equity and bond markets. Inthe empirical part of the paper, we calibrate our model, simultaneously,to the equity premium puzzle, the riskfree rate puzzle, and theexpectations puzzle, and show that the three puzzles are completelyresolved under reasonable parameter values. Thus, we establish,conclusively, the inextricable link between the equity and bond markets,both theoretically and empirically. Our model subsumes the internalhabit formation models of Sundaresan (1989) and Constantinides (1990),and, perhaps somewhat surprisingly, the external habit formation modelof Campbell and Cochrane (1999).

A Model of TFP

Title: A Model of TFP

Lagos, Ricardo

Abstract: This paper proposes an aggregative model of Total Factor Productivity(TFP) in the spirit of Houthakker (1955-1956). It considers a frictionallabor market where production units are subject to idiosyncratic shocksand jobs are created and destroyed as in Mortensen and Pissarides(1994). An aggregate production function is derived by aggregatingacross production units in equilibrium. The level of TFP is explicitlyshown to depend on the underlying distribution of shocks as well as onall the characteristics of the labor market as summarized by thejob-destruction decision. The model is also used to study the effects oflabor-market policies on the level of measured TFP.

Business Cycles in Emerging Economies: The Role of Interest Rates

Title: Business Cycles in Emerging Economies: The Role of Interest Rates

Neumeyer, Pablo A.; Perri, Fabrizio

Abstract: This paper documents the empirical relation between the interest ratesthat emerging economies face in international capital markets and theirbusiness cycles. The dataset used in the study includes quarterly datafor Argentina during 1983-2000 and for Brazil, Mexico, Korea, andPhilippines, during 1994-2000. In this sample, interest rates are veryvolatile, strongly countercyclical, and strongly positively correlatedwith net exports. Output is very volatile and consumption is morevolatile than output. These regularities are common to all emergingeconomies in the sample, but are not observed in a developed economysuch as Canada. The paper presents a dynamic general equilibrium modelof a small open economy, in which (i) firms have to pay for a fractionof the input bill before production takes place, and in which (ii) thelabor supply is independent of consumption. Using a version of themodel calibrated to Argentina’s economy, we find that interestrate shocks alone can explain 50% of output fluctuations and cangenerate business cycle patterns consistent with the regularitiesdescribed above and with the major booms and recessions in Argentina inthe last two decades. We conclude that interest rates are an importantfactor for explaining business cycles in emerging economies and furtherresearch should be devoted to fully understand their determination.

Risk Aversion and Allocation to Long-Term Bonds

Title: Risk Aversion and Allocation to Long-Term Bonds

Wachter, Jessica A.

Abstract: As risk aversion approaches infinity, the portfolio of an investor withutility over consumption at time T is shown to converge to the portfolioconsisting entirely of a bond maturing at time T. Previous work on bondallocation requires a specific model for equities, the term structure,and the investor's utility function. In contrast, the only substantiveassumption required for the analysis in this paper is that markets arecomplete. The result, which holds regardless of the underlyinginvestment opportunities and the utility function, formalizes the"preferred habitat" intuition of Modigliani and Sutch.

Portfolio and Consumption Decisions under Mean-Revering Returns: An Exact Solution for Complete Markets

Investor Protection and Equity Markets

Title: Investor Protection and Equity Markets

Shleifer, Andrei

Abstract: We present a simple model of an entrepreneur going public in anenvironment with poor legal protection of outside shareholders. Themodel incorporates elements of Becker’s (1968) “crime andpunishment” framework into a corporate finance environment ofJensen and Meckling (1976). We examine the entrepreneur’s decisionand the market equilibrium. The model is consistent with a number ofempirical regularities concerning the relationship between investorprotection and corporate finance. It also sheds light on the patterns ofcapital flows between rich and poor countries and on the politics ofreform of investor protection.

Asset Pricing in a Neoclassical Model with Limited Participation

Valuation in Dynamic Bargaining Markets

Title: Valuation in Dynamic Bargaining Markets

Duffie, Darrell; Garleanu, Nicolae; Pedersen, Lasse Heje

Abstract: We study the impact on asset prices of illiquidity associated withsearch and bargaining in an economy in which agents can trade only whenthey find each other. Marketmakers' prices are higher and bid-askspreads are lower if investors can find each other more easily. Pricesbecome Walrasian as investors' or marketmakers' search intensities getlarge. Endogenizing search intensities yields natural welfareimplications. Information can fail to be revealed through trading whensearch is difficult.

Multiple Risky Assets, Transaction Costs and Return Predictability: Implications for Portfolio Choice

Title: Multiple Risky Assets, Transaction Costs and Return Predictability:Implications for Portfolio Choice

Lynch, Anthony W.; Tan, Sinan

Abstract: Our paper contributes to the dynamic portfolio choice and transactioncost literatures by considering a multiperiod CRRA individual who facestransaction costs and who has access to multiple risky assets, all withpredictable returns. We numerically solve the individual’smultiperiod problem in the presence of transaction costs andpredictability. In particular, we characterize the investor’soptimal portfolio choice with proportional and fixed transaction costs,and with return predictability similar to that observed for the U.S.stock market. We also perform some comparative statistics to betterunderstand the nature of the no-trade region with more than one riskyasset. Throughout our focus is on the case with two risky assets. Wealso perform some utility comparisons. The calibration exercise revealssome interesting results about the relative attractiveness of the threeequity portfolios calibrated. With proportional transaction costs andi.i.d. returns, we numerically find the rebalancing rule to be ano-trade region for the portfolio weights with rebalancing to theboundary. With zero correlation, the no-trade region is a rectangleirrespective of the investor’s age. When the correlation of therisky assets is non-zero, the no-trade region becomes a parallelogram.With positive correlation, the parallelogram distorts the associatedrectangle in such a way as to take advantage of the associatedsubstitutability across the two assets that the positive correlationinduces. The converse is true for negative correlation. Turning to theallocations with return predictability, our numerical results stronglysuggest that it is the conditional return correlation that determinesthe nature of the distortion to the no-trade parallelogram. Irrespectiveof the investor’s age, the distortion always mirrors the no-tradeparallelogram distortion that we find in the i.i.d. case for returncorrelation of the same sign. The no-trade region is always larger latein life than early in life. However, the difference in no-trade areabetween early and late in life is less pronounced when returns arepredictable, consistent with intuition that the benefits fromrebalancing today are more short-lived when returns are predictable thanin the i.i.d. case.

The Financial Accelerator in Household Spending: Evidence from International Housing Markets

Title: The Financial Accelerator in Household Spending: Evidence fromInternational Housing Markets

Almeida, Heitor; Campello, Murillo; Liu, Crocker

Abstract: This paper explores contractual features of housing finance and usesdata from international housing markets to provide evidence supportingthe “financial accelerator” (Bernanke et al. 1996, 1999).Among households whose housing demand is constrained by the availabilityof collateral, those who can borrow against a larger fraction of thehousing value (achieve higher loan-to-value, or LTV ratio) have moreprocyclical debt capacity. This procyclicality in borrowing capacity isat the heart of the mechanism underlying the financial accelerator. Ourempirical strategy uses international variation in maximum LTV ratios toshow that housing prices as well as demand for new mortgages are moresensitive to income shocks in countries with higher LTV ratios,consistent with the dynamics of a collateral-based financial acceleratorin household spending. We also find that the empirical relationshipbetween maximum LTV ratios and income sensitivities is stronger incountries where housing prices are low relative to household income.Because collateral constraints are less likely to bind when housing ismore expensive (an income constraint may bind instead), these latterresults further suggest that a collateral-based accelerator is indeedbehind the observed cross-country differences in income sensitivities.

Time Series and Cross-sectional Variations of Expected Returns

Expected Returns and Expected Dividend Growth

Does Income Inequality Lead to Consumption Inequality? Evidence and Theory

Title: Does Income Inequality Lead to Consumption Inequality? Evidence and Theory

Krueger, Dirk; Perri, Fabrizio

Abstract: This paper first documents the evolution of the cross-sectional incomeand consumption distribution in the US in the past 25 years. Using datafrom the Consumer Expenditure Survey we find that a rising incomeinequality has not been accompanied by a corresponding rise inconsumption inequality. Over the period from 1972 to 1998 the standarddeviation of the log of after-tax labor income has increased by 20%while the standard deviation of log consumption has increased less than2%. Furthermore income inequality has increased both between and withineducation groups while consumption inequality has increased betweeneducation groups but mildly declined within groups. We then argue thatthese empirical findings are consistent with the hypothesis that anincrease in income volatility has been an important cause of theincrease in income inequality, but at the same time has lead to anendogenous development of credit markets, allowing households to bettersmooth their consumption against idiosyncratic income fluctuations. Wedevelop a consumption model in which the sharing of income risk islimited by imperfect enforcement of credit contracts and in which thedevelopment of financial markets depends on the volatility of theindividual income process. This model is shown to be quantitativelyconsistent with the joint evolution of income and consumption inequalityin US, while other commonly used consumption models are not.

Fixed Income Pricing

Title: Fixed Income Pricing

Dai, Qiang; Singleton, Kenneth

Abstract: This chapter surveys the literature on fixed-income pricing models,including dynamic term structure models (DTSMs) and interest ratesensitive, derivative pricing models. This literature is vast with boththe academic and practitioner communities having proposed a wide varietyof models and model-selection criteria. Central to all pricing models,implicitly or explicitly, are: (i) the identity of the state vector:whether it is latent or observable and, in the latter case, whichobservable series; (ii) the law of motion (conditional distribution) ofthe state vector under the pricing measure; and (iii) the functionaldependence of the short-term interest rate on this state vector. Aprimary objective, then, of research on fixed-income pricing has beenthe selection of these ingredients to capture relevant features ofhistory, given the objectives of the modeler, while maintainingtractability, given available data and computational algorithms.Accordingly, we overview alternative conceptual approaches tofixed-income pricing, highlighting some of the tradeoffs that haveemerged in the literature between the complexity of the probabilitymodel for the state, data availability, the pricing objective, and thetractability of the resulting model.

Term Structure Dynamics in Theory and Reality

Title: Term Structure Dynamics in Theory and Reality

Dai, Qiang; Singleton, Kenneth

Abstract: This paper is a critical survey of models designed for pricing fixedincome securities and their associated term structures of market yields.Our primary focus is on the interplay between the theoreticalspecification of dynamic term structure models and their empirical fitto historical changes in the shapes of yield curves. We begin byoverviewing the dynamic term structure models that have been fit totreasury or swap yield curves and in which the risk factors followdiffusions, jump-diffusion, or have “switching regimes." Thenthe goodness-of-fits of these models are assessed relative to theirabilities to: (i) match linear projections of changes in yields onto theslope of the yield curve; (ii) match the persistence of conditionalvolatilities, and the shapes of term structures of unconditionalvolatilities, of yields; and (iii) to reliably price caps, swaptions,and other fixed-income derivatives. For the case of defaultablesecurities we explore the relative fits to historical yield spreads.

Habit Formation and Returns on Bonds and Stocks

Wavelets in Economics and Finance: Past and Future

Title: Wavelets in Economics and Finance: Past and Future

Ramsey, James B.

Abstract: In this paper I review what insights we have gained about economic andfinancial relationships from the use of wavelets and speculate on whatfurther insights we may gain in the future. Wavelets are treated as a“lens” that enables the researcher to explore relationshipsthat previously were unobservable.

Financial Innovation, Market Participation and Asset Prices

Title: Financial Innovation, Market Participation and Asset Prices

Calvet, Laurent; Gonzalez-Eiras, Martín; Sodini, Paolo

Abstract: This paper theoretically investigates the pricing effects of financialinnovation in an economy with endogenous participation and heterogeneousincome risks. The introduction of non-redundant assets can endogenouslymodify the participation set, reduce the covariance between dividendsand participants’ consumption and thus lead to lower risk premia.This mechanism is demonstrated in a tractable exchange economy with afinite number of macroeconomic factors. Agents can freely borrow andlend, but must pay a fixed entry cost to invest in risky assets.Security prices and the participation structure are jointly determinedin equilibrium. The model is consistent with several features offinancial markets over the past few decades: substantial financialinnovation; a sharp increase in investor participation; improved riskmanagement practices; a slight increase in interest rates; and areduction in risk premia.

R&D? A Small Contribution to Productivity Growth

Title: R&D? A Small Contribution to Productivity Growth

Comín, Diego

Abstract: In this paper I calibrate the contribution of R&D investments toproductivity growth. The basis for the analysis is the free entrycondition. This yields a relationship between the resources devoted toR&D and the growth rate of technology. Since innovators are small,this relationship is not directly affected by the size of the R&Dexternalities, the presence of scale effects or diminishing returns inR&D after controlling for the growth rate of output and the interestrate. The resulting contribution of R&D to productivity growth inthe US is smaller than three to five tenths of one percentage point.Interestingly, this constitutes an upper bound for the case whereinnovators internalize the consequences of their R&D investments onthe cost of conducting future innovations. From a normative perspective,this analysis implies that, if the innovation technology takes the formassumed in the literature, the actual US R&D intensity may be thesocially optimal.

A Unified Framework for Monetary Theory and Policy Analysis

Title: A Unified Framework for Monetary Theory and Policy Analysis

Lagos, Ricardo; Wright, Randall

Abstract: Search-theoretic models of monetary exchange are based on explicitdescriptions of the frictions that make money essential. However,tractable versions of these models typically need strong assumptionsthat make them ill-suited for studying monetary policy. We propose aframework based on explicit micro foundations within which macro policycan be analyzed. The model is both analytically tractable and amenableto quantitative analysis. We demonstrate this by using it to estimatethe welfare cost of inflation. We find much higher costs than theprevious literature: our model predicts that going from 10% to 0%inflation can be worth between 3% and 5% of consumption.

Investor Sentiment and the Cross-Section of Stock Returns

Title: Investor Sentiment and the Cross-Section of Stock Returns

Baker, Malcolm; Wurgler, Jeffrey

Abstract: We examine how investor sentiment affects the cross-section of stockreturns. Theory predicts that a broad wave of sentiment willdisproportionately affect stocks whose valuations are highly subjectiveand are difficult to arbitrage. We test this prediction by studying howthe cross-section of subsequent stock returns varies with proxies forbeginning-of-period investor sentiment. When sentiment is low,subsequent returns are relatively high on smaller stocks, highvolatility stocks, unprofitable stocks, non-dividend-paying stocks,extreme-growth stocks, and distressed stocks, consistent with an initialunderpricing of these stocks. When sentiment is high, on the other hand,these patterns attenuate or fully reverse. The results are consistentwith theoretical predictions and are unlikely to reflect an alternativeexplanation based on compensation for systematic risks.

External Constraints on Monetary Policy and the Financial Accelerator

Title: External Constraints on Monetary Policy and the Financial Accelerator

Gertler, Mark; Gilchrist, Simon; Natalucci, Fabio M.

Abstract: We develop a small open economy macroeconomic model where financialconditions influence aggregate behavior. We use this model to explorethe connection between the exchange rate regime and financial distress.We show that fixed exchange rates exacerbate financial crises by tyingthe hands of the monetary authorities. We then investigate thequantitative significance by first calibrating the model to Korean dataand then showing that it does a reasonably good job of matching theKorean experience during its recent financial crisis. In particular, themodel accounts well for the sharp increase in lending rates and thelarge drop in output, investment and productivity during the 1997-1998episode. We then perform some counterfactual exercises to illustrate thequantitative significance of fixed versus floating rates both formacroeconomic performance and for welfare. Overall, these exercisesimply that welfare losses following a financial crisis are significantlylarger under fixed exchange rates relative to flexible exchange rates.

Investor Protection, Optimal Incentives, and Economic Growth

Title: Investor Protection, Optimal Incentives, and Economic Growth

Castro, Rui; Clementi, Gian Luca; MacDonald, Glenn

Abstract: Recent empirical evidence has suggested a positive association betweenvarious measures of investor protection and financial markets’development, and between financial markets’ development andeconomic growth. We introduce investor protection in a simple extensionof the two-period overlapping generations model of capital accumulationand study how it affects economic growth. Investor protection ispositively related to risk-sharing. As is standard in models ofinvestment with risk-averse agents, better protection (better risksharing) results in a larger demand for capital. This is the demandeffect. A second effect, which we call the supply effect, follows fromgeneral equilibrium restrictions. For a given aggregate capital stock,better protection (i.e., a higher demand schedule) implies a higherinterest rate. The aggregate resource constraint then implies lowerincome for the entrepreneurs (the younger cohort). As a result, currentsavings and the supply of capital in the following period decrease. Itturns out that the strength of the supply effect is greater, the tighterthe restrictions on capital flows. Therefore our model predicts that thepositive effect of investor protection on growth is stronger forcountries with lower restrictions. We find that the data provides somesupport for this prediction.

The Q-Theory of IPOs

Title: The Q-Theory of IPOs

Jovanovic, Boyan; Rousseau, Peter L.

Abstract: We find that new firms’ real investment responds much moreelastically to aggregate Tobin’s Q than does that of establishedfirms. On the financial side, IPOs respond more elastically toTobin’s Q than seasoned offerings of securities. The explanationseems to be that a high aggregate Q raises new firms’ desiredinvestment much more than it raises the desired investment ofincumbents. For the period from 1955 to 2001, the Q-elasticity of IPOsis about 1.2, and the elasticity of new-firms’ investment is about0.7. These are about 20 times more than is usual in Q regressions. Onthe other hand, the Q-elasticity of seasoned offerings is actuallynegative (-0.05), and the elasticity of incumbents’ investment is0.04. Though not statistically significant, the average of theseestimates is even smaller than is usual.

Media Frenzies in Markets for Financial Information

Title: Media Frenzies in Markets for Financial Information

Veldkamp, Laura L.

Abstract: Emerging equity markets witness occasional surges in the price level(frenzies) and increases in cross-market price dispersion (herds),accompanied by a flood of media coverage. Complementarity in informationacquisition can explain these anomalies. Because information has a highfixed cost of production, its equilibrium price is low when quantity ishigh. Investors all buy the same information because it has the lowestprice. By lowering risk, information raises the asset's price. Giventwo identical assets, investors herd: one price is higher becauseabundant information about that asset reduces its payoff risk.Transitions between low-information/low-asset-price andhigh-information/high-asset-price equilibria create price pathsresembling periodic frenzies. Using equity data and a new panel data setof news counts for 23 emerging markets, the results show that when assetmarket volatility increases, news coverage intensifies, and that morenews is correlated with higher asset prices and higher cross-marketprice dispersion.

Shakeouts and Market Crashes

Title: Shakeouts and Market Crashes

Barbarino, Alessandro; Jovanovic, Boyan

Abstract: Stock-market crashes tend to follow run-ups in prices. These episodeslook like bubbles that gradually inflate and then suddenly burst. Weshow that such bubbles can form in a Zeira-Rob type of model in whichdemand size is uncertain. Two conditions are sufficient for this tohappen: A declining hazard rate in the prior distribution over marketsize and a convex cost of investment. For the period 1971-2001 we fitthe model to the Telecom sector.

Diverging Trends in Macro and Micro Volatility: Facts

Title: Diverging Trends in Macro and Micro Volatility: Facts

Comin, Diego; Mulani, Sunil

Abstract: In this paper, we document the diverging trends in volatility of thegrowth rate of sales at the aggregate and firm level. We establish thatthe upward trend in micro volatility is not simply driven by acompositional bias in the sample studied. We argue that this new factrenders obsolete the proposed explanations for the decline in aggregatevolatility and that, given the symmetry of the diverging trends at themicro and macro level, a common explanation is highly likely. Weconclude by describing one such theory driven by market integration.

Medium Term Business Cycles

Title: Medium Term Business Cycles

Comin, Diego; Gertler, Mark

Abstract: Over the postwar, the U.S., Europe and Japan have experienced what maybe thought of as medium frequency oscillations between persistentperiods of robust growth and persistent periods of relative stagnation.These medium frequency movements, further, appear to bear some relationto the high frequency volatility of output. That is, periods ofstagnation are often associated with significant recessions, whilepersistent booms typically are either free of recessions or areinterrupted only by very modest downturns. In this paper we explore theidea of medium term cycles, which we define as reflecting the sum of thehigh and medium frequency variation in the data. We develop amethodology for identifying these kinds of fluctuations and then showthat a number of important macroeconomic time series exhibit significantmedium term cycles. The cycles feature strong procyclical movements inboth disembodied and embodied technological change, research &development, and the efficiency of resource utilization. We then developa model to explain the medium term cycle that features both disembodiedand embodied endogenous technological change, along with countercyclicalmarkups and variable factor utilization. The model is able to generatemedium term fluctuations in output, technological change, and resourceutilization that resemble the data, with a non-technological shock asthe exogenous disturbance. In particular, the model offers a unifiedapproach to explaining both high and medium frequency variation inaggregate business activity.

Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perspective

Title: Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perspective

Nieuwerburgh, Stijn Van

Abstract: In a model with housing collateral, the ratio of housing wealth to humanwealth shifts the conditional distribution of asset prices andconsumption growth. A decrease in house prices reduces the collateralvalue of housing, increases household exposure to idiosyncratic risk,and increases the conditional market price of risk. Using aggregate datafor the US, we find that a decrease in the ratio of housing wealth tohuman wealth predicts higher returns on stocks. Conditional on thisratio, the covariance of returns with aggregate risk factors explainseighty percent of the cross-sectional variation in annual size andbook-to-market portfolio returns.

Uncovering the Risk-Return Relation in the Stock Market

Title: Uncovering the Risk-Return Relation in the Stock Market

Guo, Hui; Whitelaw, Robert F.

Abstract: There is an ongoing debate in the literature about the apparent weak ornegative relation between risk (conditional variance) and return(expected returns) in the aggregate stock market. We develop andestimate an empirical model based on the ICAPM to investigate thisrelation. Our primary innovation is to model and identify empiricallythe two components of expected returns –the risk component and thecomponent due to the desire to hedge changes in investmentopportunities. We also explicitly model the effect of shocks to expectedreturns on ex post returns and use implied volatility from added optionsto increase estimation efficiency. As a result, the coefficient ofrelative risk aversion is estimated more precisely, and we find it to bepositive and reasonable in magnitude. Although volatility risk ispriced, as theory dictates, it contributes only a small amount to thetime-variation in expected returns. Expected returns are drivenprimarily by the desire to hedge changes in investment opportunities.It is the omission of this hedge component that is responsible for thecontradictory and counter-intuitive results in the existing literature.

Corporate Governance over the Business Cycle

Title: Corporate Governance over the Business Cycle

Philippon, Thomas

Abstract: I provide empirical evidence that badly governed firms respond more toaggregate shocks than do well governed firms. I build a simple modelwhere managers are prone to over invest and where shareholders are morewilling to tolerate such a behavior in good times. The modelsuccessfully explains the average profit differences as well as thecyclical behavior of sales, employment and investment for firms withdifferent governance qualities. The quantitative results suggest thatgovernance conflicts can explain 30% of aggregate volatility.

Bidder Discounts and Target Premia in Takeovers

Title: Bidder Discounts and Target Premia in Takeovers

Jovanovic, Boyan; Braguinsky, Serguey

Abstract: On news of a takeover, the sum of the stock-market values of the firmsinvolved often falls, and the value of the acquirer almost always does.Does this mean that takeovers do not raise the values of the firmsinvolved? Not necessarily. We set up a model in which the equilibriumnumber of takeovers is constrained efficient. Yet, upon news of atakeover, a target’s price rises, the bidder’s price falls,and, most of the time the joint value of the target and acquirer also falls.

Learning Asymmetries in Real Business Cycles

Title: Learning Asymmetries in Real Business Cycles

Nieuwerburgh, Stijn Van; Veldkamp, Laura

Abstract: When an economic boom ends, the downturn is generally sharp and short.When growth resumes, the boom is more gradual. Our explanation for thispattern rests on learning about productivity. When agents believeproductivity is high, they work, invest, and produce more. Moreproduction generates higher precision information. When the economypasses the peak of a productivity boom, precise estimates of theslowdown prompt quick, decisive reactions: Investment and labor fallsharply. At the end of a slump, low production yields noisy estimates ofthe recovery. The noise impedes learning, slows the recovery, and makesbooms more gradual than crashes. A calibrated model generates asymmetryin growth rates similar to macroeconomic aggregates. Fluctuations inagents’ forecast precision match observed countercyclicaldispersion in analysts’ macroeconomic forecasts. “There is,however, another characteristic of what we call the trade cycle that ourexplanation must cover; namely, the phenomenon of the crisis - the factthat the substitution of a downward for an upward tendency often takesplace suddenly and violently, whereas there is, as a rule, no such sharpturning point when an upward is substituted for a downwardtendency.” J.M. Keynes (1936)

Imperfect Knowledge and Asset Price Dynamics: Modeling the Forecasting of Rational Agents, Dynamic Prospect Theory and Uncertainty Premia on Foreign Exchange

Title: Imperfect Knowledge and Asset Price Dynamics: Modeling the Forecastingof Rational Agents, Dynamic Prospect Theory and Uncertainty Premia onForeign Exchange

Frydman, Roman; Goldberg, Michael D.

Abstract: Models using the Rational Expectations Hypothesis (REH) are widelyrecognized to be inconsistent with the observed behavior of premia infinancial markets, as well as other features of asset price dynamics.Moreover, many reasons have been advanced as to why the REH cannotgenerally represent, even approximately, the expectations behavior ofindividually rational agents. In this paper, we develop a new model ofthe equilibrium premium in the foreign exchange market that replaces theREH with the Imperfect Knowledge Forecasting (IKF) framework. Because wemaintain that agents must cope with imperfect knowledge and that theyare not grossly irrational, our IKF approach imposes only qualitativeconditions on the formation of individual forecasting models and theirupdating. We also develop a dynamic extension of the originalformulation of Kahneman and Tversky’s prospect theory. We findthat under IKF and dynamic prospect theory, the equilibrium premium onforeign exchange is positively related to the gap between the aggregateforecast of the exchange rate and its historical benchmark level. Wetest this implication, using survey data on the German mark-U.S. dollarexchange rate, and find that the behavior of the ex ante premium onforeign exchange is consistent with our model of the premium.

Political News and Stock Prices: The Case of Saddam Hussein Contracts

Title: Political News and Stock Prices: The Case of Saddam Hussein Contracts

Amihud, Yakov; Wohl, Avi

Abstract: This paper studies the association between the market’sexpectations of Saddam Hussein’s fall from power, reflected in"Saddam contract" prices, and stock prices, oil prices andexchange rates. During the war, a rise in the probability ofSaddam’s fall, which also indicated a speedy end to the war, waspositively and significantly associated with stock prices, strengthenedthe dollar against the Euro, and lowered oil prices. Before the war, arise in the probability of Saddam’s fall, which may have alsoindicated the probability of a costly war breaking out, lowered stockprices, which adjustment gradually to this information.

The Q-Theory of Mergers

Title: The Q-Theory of Mergers

Jovanovic, Boyan; Rousseau, Peter L.

Why Wait? A Century of Life Before IPO

Title: Why Wait? A Century of Life Before IPO

Jovanovic, Boyan; Rousseau, Peter L.

Boyan Jovanovic and Peter L. Rousseau

Title: Boyan Jovanovic and Peter L. Rousseau

Jovanovic, Boyan

Abstract: We model merger waves as reallocation waves, and argue that mergersspread new technology in a way that is similar to that of entry and exitof firms. We focus on two periods: 1890-1930 during which electricityand the internal combustion engine spread through the U.S. economy, and1971-2001—the Information Age.

Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors?

Title: Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors?

Sangvinatsos, Antonios; Wachter, Jessica

Abstract: We consider the consumption and portfolio choice problem of a long-runinvestor when the term structure is affine and when the investor hasaccess to nominal bonds and a stock portfolio. In the presence ofunhedgeable inflation risk, there exist multiple pricing kernels thatproduce the same bond prices, but a unique pricing kernel equal to themarginal utility of the investor. We apply our method to a three-factorGaussian model with a time-varying price of risk that captures thefailure of the expectations hypothesis seen in the data. We extend thismodel to account for time-varying expected inflation, and estimate themodel with both inflation and term structure data. The estimates implythat the bond portfolio for the long-run investor looks very differentfrom the portfolio of a mean-variance optimizer. In particular, thedesire to hedge changes in term premia generates large hedging demandsfor long-term bonds.

Does Mutual Fund Performance Vary over the Business Cycle?

Title: Does Mutual Fund Performance Vary over the Business Cycle?

Boudry, Walter; Lynch, Anthony W.; Wachter, Jessica

Abstract: Conditional factor models allow both risk loadings and performance overa period to be a function of information available at the start of theperiod. Much of the literature to date has allowed risk loadings to betime-varying while imposing the assumption that conditional performanceis constant. We develop a new methodology that allows conditionalperformance to be a function of information available at the start ofthe period. This methodology uses the Euler equation restriction thatcomes out of the factor model rather than the beta pricing formulaitself. The Euler equation restrictions that we develop can be estimatedusing GMM. It is also possible to allow the factor returns to havelonger data series than the mutual fund series as in Stambaugh (1997).We use our method to assess the conditional performance of funds in theElton, Gruber and Blake (1996) mutual fund data set. Using dividendyield to track the business cycle, we find that conditional mutual fundperformance moves with the business cycle, with all fund types exceptgrowth performing better in downturns than in peaks. The converse holdsfor growth funds, which do better in peaks than in downturns.

Information Markets and the Comovement of Asset Prices

Title: Information Markets and the Comovement of Asset Prices

Veldkamp, Laura L.

Abstract: Traditional asset pricing models predict that covariance between pricesof different assets should be lower than what we observe in the data.This model generates this high covariance within a rational expectationsframework by introducing markets for information about asset payoffs.When information is costly, rational investors will not buy informationabout all assets; they will learn about a subset. Because informationproduction has high fixed costs, competitive producers charge more forlow-demand information than for high-demand information. A price thatdeclines in quantity makes investors want to purchase a common subset ofinformation. If investors price many assets using a common subset ofinformation, then a shock to one signal is passed on as a common shockto many asset prices. These common shocks to asset prices generate`excess covariance.' The cross-sectional and time-series properties ofasset price covariance are consistent with this explanation.

A Theory of Housing Collateral, Consumption Insurance and Risk Premia

Title: A Theory of Housing Collateral, Consumption Insurance and Risk Premia

Lustig, Hanno; Nieuwerburgh, Stijn Van

Abstract: In a model with housing collateral, the ratio of housing wealth to totalwealth shifts the conditional distribution of asset prices andconsumption growth. A decrease in house prices reduces the collateralvalue of housing, increases household exposure to idiosyncratic risk,and increases the conditional market price of risk. The modelquantitatively accounts for conditional asset pricing moments,cross-sectional variation in value portfolio returns and keyunconditional asset pricing moments. The increase of the equity premiumand Sharpe ratio when collateral is scarce matches the increase observedin US data. The model also generates a return spread of value firms overgrowth firms of the magnitude observed in the data. Assets with payoffsthat lay farther in the future are less risky. Growth stocks are suchlong duration assets.

Housing Collateral and Consumption Insurance Across US Regions

Title: Housing Collateral and Consumption Insurance Across US Regions

Lustig, Hanno; Nieuwerburgh, Stijn Van

Abstract: Time-variation in the degree of risk-sharing induced by changes in thevalue of housing collateral sheds new light on the consumptioncorrelation puzzle. If debts can only be enforced to the extent thatthey are collateralized by housing wealth, a decrease in the value ofhousing collateral endogenously increases exposure to idiosyncraticrisk. This increases the cross-sectional consumption growth dispersionacross regions and it reduces the amount of regional income risk shared.We investigate risk-sharing patterns for the 30 largest US metropolitanareas and find empirical support for the housing collateral channel. Intimes when housing collateral is scarce, the dispersion of consumptiongrowth relative to income growth is twice as high as when collateral isabundant. A structural estimation of the model's consumption dynamicsimplies a time path for consumption growth dispersion that matches theone in the data. The housing collateral effect is the key element thatenables this match.