The Long Bond (with Steve Ross), June, 2013 Slides We study the behavior of the long bond, a zero-coupon bond that pays off in the far-distant future, under the assumptions that (i) the fixed-income market is complete and (ii) the state vector that drives interest rates follows a Markov chain. We show that if the pricing kernel is transition-independent—in particular, if there is an investor with separable utility or Epstein–Zin preferences—then the yield curve must slope up on average, and derive a formula that expresses the expected return on the long bond in terms of the prices of long bond options.
Simple Variance Swaps, January, 2013 NBER Working Paper 16884 Slides The events of 2008–9 disrupted volatility derivatives markets and caused the single-name variance swap market to dry up completely; it has never recovered. This paper introduces the simple variance swap, a more robust relative of the variance swap that can be priced and hedged even if the underlying asset's price can jump, and constructs SVIX, an index based on simple variance swaps that measures market volatility. SVIX is consistently lower than VIX in the time series, which rules out the possibility that the market return and stochastic discount factor are conditionally lognormal. The SVIX index points to an equity premium that—in contrast to the prevailing view in the literature—is extraordinarily volatile and that spiked dramatically at the height of the recent crisis.
The Forward Premium Puzzle in a Two-Country World, March, 2013 NBER Working Paper 17564 Slides I explore the behavior of asset prices and the exchange rate in a two-country world. When the large country has bad news, the relative price of the small country's output declines. As a result, the small country's bonds are risky, and uncovered interest parity fails, with positive excess returns available to investors who borrow at the large country's interest rate and lend at the small country's interest rate. I use a diagrammatic approach to derive these and other results in a calibration-free way.
How Much Do Financial Markets Matter? Cole-Obstfeld Revisited, November, 2010 Cole and Obstfeld (1991) asked, “How much do financial markets matter?” Emphasizing the importance of intratemporal relative price adjustment as a risk-sharing mechanism that operates even in the absence of financial asset trade, their answer was: not much. I revisit their question and find that in calibrations featuring rare disasters that generate reasonable risk premia without implausibly high risk aversion, the cost of shutting down trade in financial assets is on the order of 3 to 20 per cent of wealth.
The Lucas Orchard, Econometrica (2013), 81:1:55-111 Supplemental Material This paper investigates the behavior of asset prices in an endowment economy in which a representative agent with power utility consumes the dividends of multiple assets. The assets are Lucas trees; a collection of Lucas trees is a Lucas orchard. The model generates return correlations that vary endogenously, spiking at times of disaster. Since disasters spread across assets, the model generates large risk premia even for assets with stable cashflows. Very small assets may comove endogenously and hence earn positive risk premia even if their cashflows are independent of the rest of the economy. I provide conditions under which the variation in a small asset's price-dividend ratio can be attributed almost entirely to variation in its risk premium.
Consumption-Based Asset Pricing with Higher Cumulants, Review of Economic Studies (2013), 80:2:745-773 Local Version Online Appendix I extend the Epstein-Zin-lognormal consumption-based asset-pricing model to allow for general i.i.d. consumption growth. Information about the higher moments—equivalently, cumulants—of consumption growth is encoded in the cumulant-generating function. I use the framework to analyze economies with rare disasters, and argue that the importance of such disasters is a double-edged sword: parameters that govern the frequency and sizes of rare disasters are critically important for asset pricing, but extremely hard to calibrate. I show how to sidestep this issue by using observable asset prices to make inferences without having to estimate higher moments of the underlying consumption process. Extensions of the model allow consumption to diverge from dividends, and for non-i.i.d. consumption growth.
On the Valuation of Long-Dated Assets, Journal of Political Economy (2012), 120:2:346-358 Online Appendix I show that the pricing of a broad class of long-dated assets is driven by the possibility of extraordinarily bad news. This result does not depend on any assumptions about the existence of disasters, nor does it only apply to assets that hedge bad outcomes; indeed, it even applies to long-dated claims on the market in a lognormal world if the market's Sharpe ratio is higher than its volatility, as appears to be the case in practice.
Disasters Implied by Equity Index Options (with David Backus and Mikhail Chernov), Journal of Finance (2011), 66:6:1969-2012 We use equity index options to quantify the distribution of consumption growth disasters. The challenge lies in connecting the risk-neutral distribution of equity returns implied by options to the true distribution of consumption growth estimated from macroeconomic data. We attack the problem from three perspectives. First, we compare pricing kernels constructed from macro-finance and option-pricing models. Second, we compare option prices derived from a macro-finance model to those we observe. Third, we compare the distribution of consumption growth derived from option prices using a macro-finance model to estimates based on macroeconomic data. All three perspectives suggest that options imply smaller probabilities of extreme outcomes than have been estimated from international macroeconomic data. The third comparison yields a viable alternative calibration of the distribution of consumption growth that matches the equity premium, option prices, and the sample moments of US consumption growth.