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Household finances are confidential and discussions are limited to a subset of peers. We collect novel representative survey data to examine separately whether interactions with inner and outer social circles influence return perceptions, expectations, and exposure to a widely known financial instrument in a developed economy with multiple information sources. We find that a respondent's connectedness, proxied by perceived prevalence of information or participation in the small financial circle, improves expectation accuracy indirectly, through boosting accuracy of perceived past returns; and influences stock participation and exposure not only by influencing expectations, but also directly.

We investigate the causal effect of financial literacy on financial assets, exploiting banks information policies for identification. In Italy, banks who belong to the PattiChiari consortium have implemented policies aimed at increasing transparency and procedural simplification. These policies may affect individuals' financial literacy without involving any direct cost for clients in terms of time, effort or resources, as we show in the paper. We exploit confidential information on whether individuals have their main bank account in one bank in the PattiChiari consortium to instrument their financial literacy level. We show that these policies have a positive and significant effect on both knowledge of financial instruments and household financial assets. Our results suggest that banks information policies have the potential to be an effective tool to increase individuals' financial literacy and that the relationship between financial literacy and wealth is largely underestimated by standard regression models.

Peer effects can lead to better financial outcomes or help propagate financial mistakes across social networks. Using unique data on peer relationships and portfolio composition, we show considerable overlap in investment portfolios when an investor recommends their brokerage to a peer. We argue that this is strong evidence of peer effects and show that peer effects lead to better portfolio quality. Peers become more likely to invest in funds when their recommenders also invest, improving portfolio diversification compared to the average investor and various placebo counterfactuals. Our evidence suggests that social networks can provide good advice in settings where individuals are personally connected. Peer effects can lead to better financial outcomes or help propagate financial mistakes across social networks. Using unique data on peer relationships and portfolio composition, we show considerable overlap in investment portfolios when an investor recommends their brokerage to a peer. We argue that this is strong evidence of peer effects and show that peer effects lead to better portfolio quality. Peers become more likely to invest in funds when their recommenders also invest, improving portfolio diversification compared to the average investor and various placebo counterfactuals. Our evidence suggests that social networks can provide good advice in settings where individuals are personally connected.

We provide the first comprehensive analysis of option information for pricing the cross-section of stock returns by jointly examining extensive sets of firm and option characteristics. Using portfolio sorts and high-dimensional methods, we show that certain option measures have significant predictive power, even after controlling for firm characteristics, earning a Fama-French three-factor alpha in excess of 20% per annum. Our analysis further reveals that the strongest option characteristics are associated with information about asset mispricing and future tail return realizations. Our findings are consistent with models of informed trading and limits to arbitrage.

This paper studies whether and why algorithmic traders exhibit one of the most broadlydocumented behavioral puzzles – the disposition effect. We use trade data from the NASDAQ Copenhagen Stock Exchange merged with the weather data. We find that on average, the disposition effect for human traders is substantial and increases significantly on colder days, while for similarly-trading algorithms, it is insignificant and insensitive to the weather. This provides causal evidence of the link between human psychology and the disposition effect and suggests that algorithms can reduce psychology-related human errors. Considering the ongoing AI adoption, this may have broad implications.

The present paper proposes an overview of the existing literature covering several aspects related to environmental, social, and governance (ESG) factors. Specifically, we consider studies describing and evaluating ESG methodologies and those studying the impact of ESG on credit risk, debt and equity costs, or sovereign bonds. We further expand the topic of ESG research by including the strand of the literature focusing on the impact of climate change on financial stability, thus allowing us to also consider the most recent research on the impact of climate change on portfolio management.

In most finance papers and textbooks mean-variance preferences are usually introduced and motivated as a special case of expected utility theory. In general, the two sufficient conditions to allow this are either quadratic preferences with an arbitrary distribution of stochastic assets, or arbitrary preferences with Normally distributed assets. In the first case, the specific functional form of mean-variance preferences follows naturally. In the second case, the only specific functional form usually provided is the case of negative exponential preferences. In this note, the specific functional form for mean-variance preferences is derived for the much more realistic example of lognormally distributed assets, and constant relative risk aversion (CRRA) preferences.

In this article, we propose an original analysis of advice given by financial analysts prior to WW1. Our article focuses on the writings of A. Neymarck, one of the most popular French analysts in the early 20th Century. The creation of portfolios from a new database composed of the monthly returns of all the security types listed on the official Paris Stock Exchange from 1903 to 1912 has provided results demonstrating that Neymarck correctly identified the risk in a number of sectors. The performances of these portfolios, which were built according to Neymarck’s guidelines, confirm Neymarck’s ranking in terms of both risk and return: the richer the investor, the riskier and the more profitable his portfolio was seen to be. Finally, the Modern Portfolio Theory enables us to pinpoint the few imperfections in Neymarck’s advice, which globally appears to be driven by reliable financial analysis.

International financial integration helps to diversify risk but also may increase the trans- mission of crises across countries. We provide a quantitative analysis of this trade-off in a two-country general equilibrium model with endogenous portfolio choice and collateral con- straints. Collateral constraints bind occasionally, depending upon the state of the economy and levels of inherited debt. The analysis allows for different degrees of financial integration, moving from financial autarky to bond market integration and equity market integration. Fi- nancial integration leads to a significant increase in global leverage, doubles the probability of balance sheet crises for any one country, and dramatically increases the degree of 'contagion' across countries. Outside of crises, the impact of financial integration on macro aggregates is relatively small. But the impact of a crisis with integrated international financial markets is much less severe than that under financial market autarky. Thus, a trade-off emerges between the probability of crises and the severity of crises. Financial integration can raise or lower welfare, depending on the scale of macroeconomic risk. In particular, in a low risk environment, the increased leverage resulting from financial integration can reduce welfare of investors.

Previous research has documented strong peer effects in risk taking, but little is known about how such social influences affect market outcomes. The consequences of social interactions are hard to isolate in financial data, and theoretically it is not clear whether peer effects should increase or decrease risk sharing. We design an experimental asset market with multiple risky assets and study how exogenous variation in real-time information about the portfolios of peer group members affects aggregate and individual risk taking. We find that peer information ameliorates under-diversification that occurs in a market without such information. One reason is that peer information increases risk aversion and induces a concern for relative income position that may reduce or amplify risk taking, depending on whether the context highlights the most or least successful trader. Thus, contrary to conventional wisdom, we show that social interactions may help to reduce earnings volatility in financial markets, and we discuss implications for institutional design.

A single macroeconomic factor based on growth in the capital share of aggregate income exhibits significant explanatory power for expected returns across a range of equity characteristic portfolios and non-equity asset classes, with risk price estimates that are of the same sign and similar in magnitude. Positive exposure to capital share risk earns a positive risk premium, commensurate with recent asset pricing models in which redistributive shocks shift the share of income between capital owners, who finance consumption primarily out of asset ownership, and workers, who finance consumption primarily out of wages and salaries.

This paper analyzes the determinants of buyout funds' investment decisions. In a model in which the supply of capital is "sticky" in the short run, we link the timing of funds' investment decisions, their risk-taking behavior, and the returns they subsequently earn on their buyouts to changes in the demand for private equity, conditions in the credit market, and funds' ability to influence their perceived talent in the market. Using a proprietary dataset of 207 buyout funds that invested in 2,274 buyout targets over the last two decades, we then investigate the implications of the model. Our dataset contains precisely dated cash inflows and outflows in every portfolio company, links every buyout target to an identifiable buyout fund, and is free from reporting and survivor biases. Thus, we are able to characterize every buyout fund's precise investment choices. Our empirical findings are consistent with the model. First, established funds accelerate their investment flows and earn higher returns when investment opportunities improve, competition for deal flow eases, and credit market conditions loosen. Second, the investment behavior of first-time funds is less sensitive to market conditions. Third, younger funds invest in riskier buyouts, in an effort to establish a track record. Fourth, following periods of good performance, funds become more conservative, and this effect is stronger for younger funds.

We show that, in a frictionless and efficient market, an asset pricing model that better describes investors' behavior should better forecast stock index returns. We propose a dividend model that predicts, out-of-sample, 31.3% of the variation in annual dividend growth rates (1976-2015). Further, when learning about dividend dynamics is incorporated into a long-run risks model, the model predicts, out-of-sample, 22.4% of the variation in annual stock index returns (1976-2015). This supports the view that both investors' aversion to long-run risks and learning about these risks are important in determining asset prices and expected returns.

We introduce a canonical representation of call options, and propose a solution to two open problems in option pricing theory. The first problem was posed by (Kassouf, 1969, pg. 694) seeking “theoretical substantiation” for his robust option pricing power law which eschewed assumptions about risk attitudes, rejected risk neutrality, and made no assumptions about stock price distribution. The second problem was posed by (Scott, 1987, pp. 423-424) who could not find a unique solution to the call option price in his option pricing model with stochastic volatility–without appealing to an equilibrium asset pricing model by Hull and White (1987), and concluded: “[w]e cannot determine the price of a call option without knowing the price of another call on the same stock”. First, we show that under certain conditions derivative assets are superstructures of the underlying. Hence any option pricing or derivative pricing model in a given number field, based on an anticipating variable in an extended field, with coefficients in a subfield containing the underlying, is admissible for market timing. For the anticipating variable is an algebraic number that generates the subfield in which it is the root of an equation. Accordingly, any polynomial which satisfies those criteria is admissible for price discovery and or market timing. Therefore, at least for empirical purposes, elaborate models of mathematical physics or otherwise are unnecessary for pricing derivatives because much simpler adaptive polynomials in suitable algebraic numbers are functionally equivalent. Second, we prove, analytically, that Kassouf (1969) power law specification for option pricing is functionally equivalent to Black and Scholes (1973); Merton (1973) in an algebraic number field containing the underlying. In fact, we introduce a canonical polynomial representation theory of call option pricing convex in time to maturity, and algebraic number of the underlying–with coefficients based on observables in a subfield. Thus, paving the way for Wold decomposition of option prices, and subsequently laying a theoretical foundation for a GARCH option pricing model. Third, our canonical representation theory has an inherent regenerative multifactor decomposition of call option price that (1) induces a duality theorem for call option prices, and (2) permits estimation of risk factor exposure for Greeks by standard [polynomial] regression procedures. Thereby providing a theoretical (a) basis for option pricing of Greeks, and (b) solving Scott’s dual call option problem a fortiori with our duality theory in tandem with Riesz representation theory. Fourth, when the Wold decomposition procedure is applied we are able to construct an empirical pricing kernel for call option based on residuals from a model of risk exposure to persistent and transient risk factors. Keywords: number theory; price discovery; derivatives pricing; asset pricing; canonical representation; Wold decomposition; empirical pricing kernel; option Greeks; dual option pricing

Using the pandemic as a laboratory, we show that asset markets assign a time- varying price to firms' disaster risk exposure. In 2020 the cross-section of realized and expected stock returns reflected firms' different exposure to the pandemic, as measured by their vulnerability to social distancing. Realized and expected return differentials initially widened and then narrowed, but disaster exposure still commanded a risk premium in December 2020. When inferred from market outcomes, resilience correlates not only with social distancing, but also with cash and environmental ratings. However, vulnerability to social distancing is the only characteristic that identifies persistently scarred firms.

We study risk taking in a panel of subjects in Wuhan, China - before, during the COVID-19 crisis, and after the country reopened. Subjects in our sample traveled for semester break in January, generating variation in exposure to the virus and quarantine in Wuhan. Higher exposure leads subjects to reduce planned risk taking, risky investments, and optimism. Our findings help unify existing studies by showing that aggregate shocks affect general preferences for risk and economic expectations, while heterogeneity in experience further affect risk taking through beliefs about individuals’ own outcomes such as luck and sense of control. JEL Classification: G50, G51, G11, D14, G41

Retail investors pay over twice as much attention to local companies than non-local ones, based on Google searches. News volume and volatility amplify this attention gap. Attention appears causally related to perceived proximity: first, acquisition by a nonlocal company is associated with less attention by locals, and more by nonlocals close to the acquirer; second, COVID-19 travel restrictions correlate with a drop in relative attention to nonlocal companies, especially in locations with fewer flights after the outbreak. Finally, local attention predicts volatility, bid-ask spreads and nonlocal attention, not viceversa. These findings are consistent with local investors having an information-processing advantage.

Extant research shows that CEO characteristics affect earnings management. This paper studies how investors infer a specific characteristic of CEOs, namely moral commitment to honesty, from earnings management and how this perception – in conjunction with their own social and moral preferences – shapes their investment choices. We conduct two laboratory experiments simulating investment choices. Our results show that participants perceive a CEO to be more committed to honesty when they infer that the CEO engaged less in earnings management. For investment decisions, a one standard deviation increase in a CEO's perceived commitment to honesty compared to another CEO reduces the relevance of differences in the CEOs’ claimed future returns by 40%. This effect is most prominent among investors with a proself value orientation. To prosocial investors, their own honesty values and those attributed to the CEO matter directly, while returns play a secondary role. Overall, perceived CEO honesty matters to different investors for distinct reasons.

We use unique data on banks' private risk assessments of corporate borrowers to quantify how competition among banks affect the risk sensitivity of interest rates in the Norwegian credit market. We show that an increase in competition makes corporate lending rates less sensitive to banks' own assessment of borrower risk and this is more pronounced in market segments with higher degree of asymmetric information. Our results are driven by banks with low franchise values, outlining a novel channel of how the competition-fragility nexus can operate.

Expectations about economic variables vary systematically across genders. In the domain of inflation, women have persistently higher expectations than men. We argue that traditional gender roles are a significant factor in generating this gender expectations gap as they expose women and men to different economic signals in their daily lives. Using unique data on the participation of men and women in household grocery chores, their resulting exposure to price signals, and their inflation expectations, we document a tight link between the gender expectations gap and the distribution of grocery shopping duties. Because grocery prices are highly volatile, and consumers focus disproportionally on positive price changes, frequent exposure to grocery prices increases perceptions of current inflation and expectations of future inflation. The gender expectations gap is largest in households whose female heads are solely responsible for grocery shopping, whereas no gap arises in households that split grocery chores equally between men and women. Our results indicate that gender differences in inflation expectations arise due to social conditioning rather than through differences in innate abilities, skills, or preferences.

We exploit a modification to Sustainalytics' environmental, social, and governance (ESG) rating methodology, which is subsequently adopted by Morningstar, to study whether ESG ratings are salient for stock pricing. We show that the inversion of the rating scale but not new information leads some investors to make incorrect assessments about the meaning of the change in ESG ratings. They buy (sell) stocks they misconceive as ESG upgraded (downgraded) even when the opposite is true. This trading behavior exerts transitory price pressure on a↵ected stocks. Our paper highlights the importance of ESG ratings for investors and consequently for asset prices. September 23, 2021

Tax-qualified vehicles helped U.S. private-sector workers accumulate {dollar}25Tr in retirement assets. An often-overlooked important institutional feature shaping decumulations from these retirement plans is the "Required Minimum Distribution" (RMD) regulation, requiring retirees to withdraw a minimum fraction from their retirement accounts or pay excise taxes on withdrawal shortfalls. Our calibrated lifecycle model measures the impact of RMD rules on financial behavior of heterogeneous households during their worklives and retirement. We show that proposed reforms to delay or eliminate the RMD rules should have little effects on consumption profiles but more impact on withdrawals and tax payments for households with bequest motives.

The disposition effect is implicitly assumed to be constant over time. However, drivers of the disposition effect (preferences and beliefs) are rather countercyclical. We use individual investor trading data covering several boom and bust periods (2001-2015). We show that the disposition effect is countercyclical, i.e. is higher in bust than in boom periods. Our findings are driven by individuals being 25% more likely to realize gains in bust than in boom periods. These changes in investors' selling behavior can be linked to changes in investors' risk aversion and in their beliefs across financial market cycles.

We examine time discounting factors in an international survey. Our analysis reveals a significant relationship between time discount factors and historical equity premiums across 27 countries. This result implies that higher historical equity risk premiums are observed in countries where survey participants tend to be more short-term oriented. This finding is consistent with the explanation of the equity premium puzzle provided by myopic loss aversion.

We study how allowing agents to use debt as collateral affects asset prices, leverage, and interest rates in a general equilibrium, heterogeneous-agent model with collateralized financial contracts and multiple states of uncertainty. In the absence of debt collateralization, multiple contracts are traded in equilibrium, with some agents borrowing using risky debt and others borrowing with risk-free debt. When agents can use debt contracts as collateral to borrow from other agents, margin requirements decrease, asset prices increase, and the interest rate on risky debt decreases. We characterize equilibrium for N states and L levels of debt collateralization and prove that enough levels of debt collateralization creates an equilibrium featuring maximal leverage on all debt contracts. In the dynamic model, debt collateralization creates larger asset price volatility.

Using only daily data on bond and stock returns, we identify and characterize flight to safety (FTS) episodes for 23 countries. On average, FTS days comprise less than 3% of the sample, and bond returns exceed equity returns by 2.5 to 4%. The majority of FTS events are country-specific not global. FTS episodes coincide with increases in the VIX and the Ted spread, decreases in consumer sentiment indicators and appreciations of the Yen, Swiss franc, and US dollar. The financial, basic materials and industrial industries under-perform in FTS episodes, but the telecom industry outperforms. Money market instruments, corporate bonds, and commodity prices (with the exception of metals, including gold) face abnormal negative returns in FTS episodes. Hedge funds, especially those belonging to the event-driven styles, display negative FTS betas, after controlling for standard risk factors. Liquidity deteriorates on FTS days both in the bond and equity markets. Both economic growth and inflation decline right after and up to a year following a FTS spell.

In fifteen European countries, China, and the US, stocks and business equity as a share of total household assets are represented by an increasing and convex function of income/wealth. A parsimonious model fitted to the data shows why background labor- income risk can explain much of this risk-taking pattern. Uncontrollable labor-income risk stresses middle-income households more because labor income is a larger fraction of their total lifetime resources compared with the rich. In response, middle-income households re-duce (controllable) financial risk. Richer households, having less pressure, can afford more risk-taking. The poor take low risk because they avoid jeopardizing their subsistence consumption.

We use data from a German online brokerage and a survey to show that retail investors sharply reduce risk-taking in response to nearby firm bankruptcies, which are not pre- dictive of returns. The effects on trading are spatially highly concentrated, immediate and not persistent. They seem to operate through more pessimistic expected returns and increased risk aversion and do not reflect wealth effects or changes in background risks. Investors learn about bankruptcies through immediate coverage in local newspapers. Our findings suggest that non-informative local experiences that make downside risks of stock investment more salient contribute to idiosyncratic short-term fluctuations in trading.

We analyze the ESG rating criteria used by prominent agencies and show that there is a lack of a commonality in the definition of ESG (i) characteristics, (ii) attributes and (iii) standards in defining E, S and G components. We provide evidence that heterogeneity in rating criteria can lead agencies to have opposite opinions on the same evaluated companies and that agreement across those providers is substantially low. Those alternative definitions of ESG also affect sustainable investments leading to the identification of different investment universes and consequently to the creation of different benchmarks. This implies that in the asset management industry it is extremely dicult to measure the ability of a fund manager if financial performances are strongly conditioned by the chosen ESG benchmark. Finally, we find that the disagreement in the scores provided by the rating agencies disperses the effect of preferences of ESG investors on asset prices, to the point that even when there is agreement, it has no impact on financial performances.

We apply numerical dynamic programming techniques to solve discrete-time multi-asset dynamic portfolio optimization problems with proportional transaction costs and shorting/borrowing constraints. Examples include problems with multiple assets, and many trading periods in a finite horizon problem. We also solve dynamic stochastic problems, with a portfolio including one risk-free asset, an option, and its underlying risky asset, under the existence of transaction costs and constraints. These examples show that it is now tractable to solve such problems.

Cryptocurrencies have received growing attention from individuals, the media, and regulators. However, little is known about the investors whom these financial instruments attract. Using administrative data, we describe the investment behavior of individuals who invest in cryptocurrencies with structured retail products. We find that cryptocurrency investors are active traders, prone to investment biases, and hold risky portfolios. In line with attention effects and anticipatory utility, we find that the average cryptocurrency investor substantially increases log-in and trading activity after his or her first cryptocurrency purchase. Our results document which investors are more likely to adopt new financial products and help inform regulators about investors' vulnerability to cryptocurrency investments.

Economic theory predicts that a reduction in background risk should induce financial risk-taking, particularly for individuals with low stock market participation costs. Hence, health insurance coverage could affect financial risk-taking by offsetting health-related background risk. We use a regression discontinuity design to examine whether Medicare eligibility at age 65 increases stockholding in the US and find that it does so for those with college education, but not for their less-educated counterparts who face higher stock market participation costs. Our results are unlikely due to the reduction of medical expenses associated with Medicare coverage because the latter does not affect bondholding.

This paper studies a household's optimal demand for a reverse mortgage. These contracts allow homeowners to tap their home equity to finance consumption needs. In stylized frameworks, we show that the decision to enter a reverse mortgage is mainly driven by the differential between the aggregate appreciation of the house price and principal limiting factor on the one hand and the funding costs of a household on the other hand. We also study a rich life-cycle model that can explain the low demand for reverse mortgages as observed in US data. In this model, we analyze the optimal response of a household that is confronted with a health shock or financial disaster. If an agent suffers from an unexpected health shock, she reduces the risky portfolio share and is more likely to enter a reverse mortgage. On the other hand, if there is a large drop in the stock market, she keeps the risky portfolio share almost constant by buying additional shares of stock. Besides, the probability to take out a reverse mortgage is hardly affected.

This paper studies why investors buy dividend-paying assets and how they time their consumption accordingly. We combine administrative bank data linking customers’ consumption transactions and income to detailed portfolio data and survey responses on financial behavior. We find that private consumption is excessively sensitive to dividend income. Investors across wealth, income, and age distributions increase spending precisely around days of dividend receipt. Importantly, the consumption response is driven by financially prudent investors who select dividend portfolios, anticipate dividend income, and plan consumption accordingly. Our results contribute to the literature on a dividend clientele and provide evidence of ‘planned’ excess sensitivity.

This thesis presents three essays in the field of empirical and quantitative macroeconomics. The essays focus on the macroeconomic consequences of credit-market imperfections. The first chapter is about the dynamics of the sovereign credit, while the rest two chapters are on the corporate/business credit. In terms of methodologies, panel-data approaches are applied in both Chapter 1 and Chapter 2. Structural quantitative methods, on the other hand, are used in Chapter 1 and Chapter 3.In Chapter 1, which is joint work with Almuth Scholl, we study the dynamic interaction between sovereign default risk, taxation, and the underground economy. The study is motivated by the observation that in the wake of sovereign debt crises, many countries have adopted fiscal consolidation policies in order to reduce public debt and to restore creditworthiness. However, particularly in crisis-prone countries, substantial underground activities undermine tax enforcement. We first conduct an empirical analysis. For a large sample of countries, we find that the size of the underground economy is positively correlated with sovereign debt and interest spreads. We rationalize these empirical regularities within a quantitative model of sovereign default that explicitly accounts for underground activities. We study optimal fiscal policy in the presence of limited tax enforcement and default risk using the concept of Markov-perfect equilibria, in which the government moves first and the households form expectations about future public policies. In a quantitative exercise, we analyze the properties of optimal public policies and the private sector's responses and study the dynamics of a default event with particular focus on the underground sector. Our simulation results reveal that the theoretical framework replicates the empirical regularities very well. In particular, our model predicts that the size of the underground economy is positively correlated with sovereign debt and interest spreads. We show that during a debt crises, the dynamic interaction between sovereign default risk and the underground economy creates a vicious circle: Higher sovereign risk premia tighten the endogenous borrowing constraint and force the government to raise taxes. Tax hikes, however, induce the private sector to invest less and to evade taxes by producing in the underground sector. In turn, falling tax revenues force the government to either implement further tax hikes or to default. Eventually, rasing taxes becomes too costly and the government finds it optimal to default Our quantitative findings suggest that the underground economy fosters sovereign default risk and deepens debt crises.In the second chapter, we ask the following question: Has the financial sector become more efficient over time? It is natural to believe that the financial efficiency has improved, at least in an advanced economy such as the United States. However, some authors, such as Philippon (2015) and Bazot (2018), show that it might not be the case. This chapter revisits the estimation of financial efficiency. In this chapter, we propose a regression method to assess the time trend in the firm's intermediation cost of external credit. We define the intermediation cost as the part of the unit cost of the external credit finance that is unrelated to the risk premium. We find that the intermediation cost has decreased significantly over the period of 1983Q1-2007Q4, which has substantially reduced firm's borrowing cost. On average, the fall in the intermediation cost leads to a reduction by 0.57-0.71 percentage point in the ratio of interest expense over revenue, and a decrease by 0.78-0.79 percentage point in the ratio of interest expense over book value of debt. The estimation results are robust against different sample components and against alternative measures of the risk-free rate and inflation. The reduction in the intermediation cost implies that the financial efficiency has improved in the US corporate credit market. We also assess the cross-sectional average risk premium and unit cost over the same period of time, but find mixed results.Chapter 3 is motivated by the empirical evidence in Chapter 2, and explores the macroeconomic implications of such decrease in the intermediation cost. The chapter is motivated by the fact that over the past decades, there has been a dramatic credit boom in the United States, coupled with decreasing asset returns and rising inequality. It analyzes whether the decreasing intermediation cost of borrowing is an explanation for these developments. We first construct a simple two-period model, followed by a fully dynamic model based on Angeletos (2007), which we apply to the United States in a quantitative exercise. We find that the macroeconomic effects of the fall in intermediation costs are amplified by two feedback loops: one is between the capital market and the credit market, and another is between the capital-credit market and the wealth distribution. We show that, due to lower intermediation costs, the credit market experiences a "simultaneous" expansion of credit demand and credit supply. As a result, the real risk-free interest rate barely changes. The capital market also expands, leading to a decrease in the returns on capital. The feedback loops exaggerate the capital-income risk and increase the average returns on investment among leveraged investors, driving up the overall wealth and income inequality. In a quantitative exercise, we find that much of the rise in the top-end wealth inequality during 1980-2007 could be explained by the reduction in the intermediation costs. In terms of welfare, we find that the welfare decreases for the households in the bottom-90% wealth group, while it improves for households in other groups. published

Using harmonized wealth data and a novel decomposition approach, we show that cohort effects exist in the income profiles of asset and debt portfolios for a sample of European countries, the U.S. and Canada. We find that younger households' participation decisions in assets are more responsive to income than older households. Family structure plays a significant role in explaining cross-country differences for both cohorts. Examining institutional differences, we find that in more financially developed and economically open countries, households are less likely to own housing but more likely to be in debt. Typical mortgage characteristics and mathematical literacy are also correlated with debt participation across countries. These findings have important implications for policy setting during times of financial unease for the young, as well as for the future in helping secure adequate income for the elderly. Our results show that there is scope for policies which promote asset participation for young households and debt participation, where there is a need for consumpation smoothing, for older households.

Capital Asset Pricing Model (CAPM) alpha explains hedge fund flows better than alphas from more sophisticated models. This suggests that investors pool together sophisticated model alpha with returns from exposures to traditional (except for the market) and exotic risks. We decompose performance into traditional and exotic risk components and find that while investors chase both components, they place greater relative emphasis on returns associated with exotic risk exposures that can only be obtained through hedge funds. However, we find little evidence of persistence in performance from traditional or exotic risks, which cautions against investors’ practice of seeking out risk exposures following periods of recent success.

We study whether mutual funds systematically manage downside risk of their portfolios in ways that improve their performance. We find that actively managed mutual funds on average possess positive downside risk timing ability. Funds investing in large-cap and value stocks have stronger downside risk timing skills. Managers adjust funds’ downside risk exposure in response to macroeconomic information. Funds more skilled in timing downside risk outperform those which are not by 13.8bp per month (or 1.67 percent per year). JEL classification: G10, G11.

Berkshire Hathaway has realized a Sharpe ratio of 0.76, higher than any other stock or mutual fund with a history of more than 30 years, and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors. Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks. Decomposing Berkshires’ portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett’s returns are more due to stock selection than to his effect on management. These results have broad implications for market efficiency and the implementability of academic factors.

The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953--2009, it was unusually high in the early 1980''s and negative in the 2000''s, particularly in the downturns of 2000--02 and 2007--09. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by four state variables: the real interest rate, temporary and permanent components of expected inflation, and the ""nominal-real covariance"" of inflation and the real interest rate with the real economy. The last of these state variables enables the model to ...fit the changing covariance of bond and stock returns. Log bond yields and term premia are quadratic in these state variables, with term premia determined by the nominal-real covariance. The concavity of the yield curve - the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields - is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980''s, driving down term premia.

This paper evaluates the effects of capital controls on firm-level stock returns and real investment using data from Brazil. On average, there is a statistically significant drop in cumulative abnormal returns consistent with an increase in the cost of capital for Brazilian firms following capital control announcements. Large firms and the largest exporting firms appear less negatively affected compared to external-finance-dependent firms, and capital controls on equity inflows have a more negative announcement effect on equity returns than those on debt inflows. Overall, the findings have implications for macro-finance models that abstract from heterogeneity at the firm level to examine the optimality of capital control taxation.

The equity premium — the expected return on the aggregate stock market less the government bill rate – is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces more reliable estimates under a wide range of specifications.

Banks are optimally opaque institutions. They produce debt for use as a transaction medium (bank money), which requires that information about the backing assets – loans – not be revealed, so that bank money does not fluctuate in value, reducing the efficiency of trade. This need for opacity conflicts with the production of information about investment projects, needed for allocative efficiency. Intermediaries exist to hide such information, so banks select portfolios of information-insensitive assets. For the economy as a whole, firms endogenously separate into bank finance and capital market/stock market finance depending on the cost of producing information about their projects.

This paper analyzes the relationship between dispositional optimism and stock investments, controlling for cognitive skills and personality traits such as trust, social interactions and risk aversion. We use data from the Survey of Health, Ageing and Retirement in Europe (SHARE) on investors aged 50+ in twelve European countries. Our results show that dispositional optimism and personality matter for financial decisions. Optimism is positively and significantly related to both the ownership of stocks and the share of gross financial wealth invested in these assets and its role is especially relevant for risk tolerant investors and investors with little trust in others.

We examine the activity and performance of a large panel of individual investors (approximately 70,000 investors and their daily returns over the 2000 to 2010 period) in Sweden's Premium Pension System. We document strong inertia in individuals' choices and changes of mutual funds. We find that active investors outperform passive investors, and that there is a causal effect of fund changes on performance. The outperformance is primarily the result of dynamic fund selection. Activity is beneficial for the individual investor, whereas extreme flows out of mutual funds (which we attribute to financial advisors) affect funds' net asset value negatively for all investors.

This paper presents empirical evidence on the increasing allocation of institutional investors to emerging markets economies. It seeks to understand which factors are driving this increase, and how this relates to portfolio flows to such economies. By making use of the Emerging Portfolio Fund Research database, it estimates asset demand equations for emerging markets equities and bonds by institutional investors from advanced countries. These are estimated using recent advances in the panel autoregressive distributed lags models literature. Two key results emerge: balance sheet conditions of institutional investors and foreign exchange reserves in emerging markets affect asset allocation; secondly, quarterly returns matter for long-run asset allocations and the portfolio adjustment process is quick. These findings suggest that portfolio flows by institutional investors could still be procylical despit their more long-term horizon, and that additional variables should be monitored to ensure financial stability.

The disposition effect, i.e., the tendency to sell winning stocks too early and losing stocks too late is one of the most frequently observed and discussed biases of financial investors. We investigate in a laboratory experiment whether the option of automatic selling devices causally reduces investors’ disposition effect. Our investors can actively buy and sell assets, and, in the treatment group, additionally use stop-loss and take-gain options to automatically sell assets. Investors who had access to the automatic selling devices had significantly smaller disposition effects. The reduction was driven by a significant increase in realized losses. The proportion of winners realized was similar in both treatments. Additionally, our setup provides new evidence on which reference prices investors relate to when choosing limits for automatic sales.

Purpose The purpose of this paper is to investigate the effect of default risk and transaction costs on the investor’s asset allocation and the liquidity premium. More precisely, it aims at answering the following question: can default risk generate a first-order effect on the investor’s asset allocation and a liquidity premium of the same order of magnitude as transaction costs? Design/methodology/approach The author proposes a very simple consumption-investment model in which an infinitely lived investor allocates her wealth between a risky asset and a riskless security, and incurs in proportional transaction costs when exchanging them. In addition, the risky asset may default at some random time, thus reducing the available wealth of the agent. Two different scenarios of default risk are considered. In the total default scenario, the value of the risky asset drops to zero when default occurs, whereas, in the partial default case, the proceeds from the liquidation of the risky asset amount to 50 percent of its value. Findings The paper shows that default risk can generate a first-order effect on the investor’s asset allocation. On the contrary, the liquidity premium is one order of magnitude smaller than the transaction costs, implying that the additional source of risk determined by the possibility of default is not able to generate a first-order effect on asset pricing. Originality/value To the author knowledge, this is the first paper that investigates the interaction of default risk and transaction costs on the investor’s asset allocation and its effects on the liquidity premium.

This paper investigates the determinants of value and growth investing in a large administrative panel of Swedish residents over the 1999-2007 period. We document strong relationships between a household's portfolio tilt and the household's financial and demographic characteristics. Value investors have higher financial and real estate wealth, lower leverage, lower income risk, lower human capital, and are more likely to be female than the average growth investor. Households actively migrate to value stocks over the life-cycle and, at higher frequencies, dynamically offset the passive variations in the value tilt induced by market movements. We verify that these results are not driven by cohort effects, financial sophistication, biases toward popular or professionally close stocks, or unobserved heterogeneity in preferences. We relate these household-level results to some of the leading explanations of the value premium.

We develop a structural econometric model to elicit household-specific expectations about future financial asset returns and risk attitudes by using data on observed portfolio holdings and self-assessed willingness to bear financial risk. Our framework assumes that household portfolios are subject to short-selling constraints in stocks and bonds, and that financial investment decisions are taken conditional on real estate and business wealth. We derive an explicit solution for the model, and estimate its parameters using the US Survey of Consumer Finances from 1995 to 2013. The results show that our modified mean-variance model fits the data adequately, and that the demographic, occupational and educational characteristics of the investors are relevant in shaping risk aversion and return expectations. In contrast, wealth, income, and past market performance have limited impacts on expectations and risk aversion.