Modeling credit contagion via the updating of fragile beliefs
We propose a tractable equilibrium model for pricing defaultable bonds that are subject to contagion risk. Contagion arises because agents with ?fragile beliefs? are uncertain about both the underlying state of the economy and the posterior probabilities associated with these states. As such, agents adopt a robust decision rule for updating that leads them to over-weight the posterior probabilities of ?bad? states. We estimate the model using panel data on sovereign Euro-zone CDS spreads during the recent crisis, and find that it captures levels and dynamics of spreads better than traditional ...
Given the importance of return volatility on a number of practical financial management decisions, the efforts to provide good real- time estimates and forecasts of current and future volatility have been extensive. The main framework used in this context involves stochastic volatility models. In a broad sense, this model class includes GARCH, but we focus on a narrower set of specifications in which volatility follows its own random process, as is common in models originating within financial economics. The distinguishing feature of these specifications is that volatility, being inherently ...
Asymmetric Information, Dynamic Debt Issuance, and the Term Structure of Credit Spreads
We propose a tractable model of a firm?s dynamic debt and equity issuance policies in the presence of asymmetric information. Because ?investment-grade? firms can access debt markets, managers who observe a bad private signal can both conceal this information and shield shareholders from infusing capital into the firm by issuing new debt to service existing debt, thus avoiding default. The implication is that the ?asymmetric information channel? can generate jumps to default (from the creditors? perspective) only for those "high-yield" firms that have exhausted their ability to borrow. Thus, ...
Explaining asset pricing puzzles associated with the 1987 market crash
The 1987 market crash was associated with a dramatic and permanent steepening of the implied volatility curve for equity index options, despite minimal changes in aggregate consumption. We explain these events within a general equilibrium framework in which expected endowment growth and economic uncertainty are subject to rare jumps. The arrival of a jump triggers the updating of agents' beliefs about the likelihood of future jumps, which produces a market crash and a permanent shift in option prices. Consumption and dividends remain smooth, and the model is consistent with salient features ...
Portfolio choice over the life-cycle when the stock and labor markets are cointegrated
We study portfolio choice when labor income and dividends are cointegrated. Economically plausible calibrations suggest young investors should take substantial short positions in the stock market. Because of cointegration the young agent's human capital effectively becomes.
Core and 'Crust': Consumer Prices and the Term Structure of Interest Rates
We propose a no-arbitrage model that jointly explains the dynamics of consumer prices as well as the nominal and real term structures of risk-free rates. In our framework, distinct core, food, and energy price series combine into a measure of total inflation to price nominal Treasuries. This approach captures different frequencies in inflation fluctuations: Shocks to core are more persistent and less volatile than shocks to food and, especially, energy (the 'crust'). We find that a common structure of latent factors determines and predicts the term structure of yields and inflation. The model ...
The Interplay Between Financial Conditions and Monetary Policy Shocks
We study the interplay between monetary policy and financial conditions shocks. Such shocks have a significant and similar impact on the real economy, though with different degrees of persistence. The systematic fed funds rate response to a financial shock contributes to bringing the economy back towards trend, but a zero lower bound on policy rates can prevent this from happening, with a significant cost in terms of output and investment. In a retrospective analysis of the U.S. economy over the past 20 years, we decompose the realization of economic variables into the contributions of ...
Why Does the Yield-Curve Slope Predict Recessions?
Why is an inverted yield-curve slope such a powerful predictor of future recessions? We show that a decomposition of the yield curve slope into its expectations and risk premia components helps disentangle the channels that connect fluctuations in Treasury rates and the future state of the economy. In particular, a change in the yield curve slope due to a monetary policy easing, measured by the current real-interest rate level and its expected path, is associated with an increase in the probability of a future recession within the next year. In contrast, a decrease in risk premia is ...
Do bonds span volatility risk in the U.S. Treasury market? a specification test for affine term structure models
We investigate whether bonds span the volatility risk in the U.S. Treasury market, as predicted by most 'affine' term structure models. To this end, we construct powerful and model-free empirical measures of the quadratic yield variation for a cross-section of fixed- maturity zero-coupon bonds ('realized yield volatility') through the use of high-frequency data. We find that the yield curve fails to span yield volatility, as the systematic volatility factors are largely unrelated to the cross- section of yields. We conclude that a broad class of affine diffusive, Gaussian-quadratic and affine ...
Can standard preferences explain the prices of out-of-the-money S&P 500 put options?
The 1987 stock market crash occurred with minimal impact on observable economic variables (e.g., consumption), yet dramatically and permanently changed the shape of the implied volatility curve for equity index options. Here, we propose a general equilibrium model that captures many salient features of the U.S. equity and options markets before, during, and after the crash. The representative agent is endowed with Epstein-Zin preferences and the aggregate dividend and consumption processes are driven by a persistent stochastic growth variable that can jump. In reaction to a market crash, the ...