- Title:
- Can Ambiguity Aversion Explain the Equity Home Bias?
- Author:
- Kirabaeva, Koralai
- Collector:
- Kirabaeva, Koralai
- Description:
- This paper examines how ambiguity about the distribution of asset returns affects equilibrium prices and equity holdings in a two-country CARA-normal setting. All investors possess the same information about the set of possible states and the corresponding returns distribution in each state, but they have different beliefs about the likelihood of these states. Optimism and overconfidence refer to the distorted beliefs about expected mean and dispersion of the asset returns distributions, respectively. I analyze and quantify the effects of optimism and overconfidence on asset prices and asset holdings when investors are ambiguity averse. Furthermore, I show that the equity home bias is larger in countries with smaller market capitalization. I investigate whether the equity home bias observed in data can be explained by intermediate degrees of ambiguity aversion.
- Date:
- 2009
- Notes:
- Presented at SITE on August 12, 2009
1 - 22 of 22
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- Title:
- Constructive Decision Theory
- Author:
- Blume, Larry and Easley, David
- Collector:
- Blume, Larry and Easley, David
- Date:
- 2009
- Notes:
- Presented at SITE on August 13, 2009
- Title:
- Defaults, Shortsales and the Social Costs of Volatility
- Author:
- Nakata, Hiro
- Collector:
- Nakata, Hiro
- Description:
- This paper examines the welfare effects of credit and shortsales constraints and limited liability/minimum consumption guarantee in an overlapping generations (OLG) model with rational beliefs in the sense of Kurz (1994). To measure the social welfare, it instead adopts an ex post social welfare concept in the sense of Hammond (1981), since the standard Pareto criterion becomes inappropriate when heterogeneous beliefs are present. Simulation results indicate a trade-off between a larger opportunity set and a larger room for 'mistakes', and thus, the existence of a socially optimal level of various constraints.
- Date:
- 2009
- Notes:
- Presented at SITE on August 11, 2009
- Title:
- Diverse Beliefs and Time Variability of Risk Premia
- Author:
- Kurz, Mordecai and Motolese, Maurizio
- Collector:
- Kurz, Mordecai and Motolese, Maurizio
- Description:
- Why do risk premia vary over time? We examine this problem theoretically and empirically by studying the effect of market belief on risk premia. Individual belief is taken as a fundamental, primitive, state variable. Market belief is observable, it is central to the empirical evaluation and we show how to measure it. The asset pricing model we use is familiar from the noisy REE literature but we adapt it to an economy with diverse beliefs. We derive the equilibrium asset pricing and the implied risk premium. Our approach permits a closed form solution of prices hence we trace the exact effect of market belief on the time variability of asset prices and risk premia. We test empirically the theoretical conclusions. Our main result is that, above the effect of business cycles on risk premia, fluctuations in market belief have significant independent effect on the time variability of risk premia. We study the premia on long positions in Federal Funds Futures, 3-month and 6-month Treasury Bills. The annual mean risk premium on holding such assets for 1-12 months is about 40-60 basis points and we find that, on average, the component of market belief in the risk premium exceeds 50% of the mean. Since time variability of market belief is large, this component frequently exceeds 50% of the mean premium. This component is larger the shorter is the holding period of an asset and it dominates the premium for very short holding returns of less than 2 months. As to the structure of the premium we show that when the market holds abnormally favorable belief about the future payoff of an asset the market views the long position as less risky hence the risk premium on that asset declines. More generally, periods of market optimism (i.e. "bull" markets) are shown to be periods when the market risk premium is low while in periods of pessimism (i.e. "bear" markets) the market's risk premium is high. Fluctuations in risk premia are thus inversely related to the degree of market optimism about future prospects of asset payoffs. This effect is strong and economically very significant.
- Date:
- 2009
- Notes:
- Presented at SITE on August 10, 2009
- Title:
- Evolutionary Selection of Individual Expectations and Aggregate Outcomes
- Author:
- Anufriev, Mikhail and Hommes, Cars
- Collector:
- Anufriev, Mikhail and Hommes, Cars
- Description:
- In recent 'learning to forecast' experiments with human subjects of Hommes, et al. (2005), three different patterns in aggregate price behavior have been observed: slow monotonic convergence, permanent price oscillations and dampened price fluctuations. These different aggregate outcomes are at odds with a representative agent who is fully rational or employs a single adaptive learning rule. We construct a simple model of individual learning, based on performance based evolutionary selection or reinforcement learning among heterogeneous expectations rules, explaining these different aggregate outcomes. Agents are boundedly rational and choose from a small set of simple price prediction rules, such as naive, adaptive or trend following expectations, similar to individual rules estimated in the experiment. Agents update their active rule by evolutionary selection based upon forecasting performance. Simulations show that after some initial learning phase, coordination on a common rule occurs. Out-of-sample predictive power of our model is higher than of the rational or other homogeneous expectations benchmarks. Our results show that heterogeneity in expectations is crucial to describe individual forecasting behavior as well as aggregate price behavior.
- Date:
- 2009
- Notes:
- Presented at SITE on August 13, 2009
- Title:
- Exchange Rates and Asset Prices: Heterogeneous Agents at Work
- Author:
- Piccillo, Giulia
- Collector:
- Piccillo, Giulia
- Description:
- This paper merges two branches of the literature. On the one hand we have a heterogeneous agents framework, which for the first time is used to model exchange rates as well as stock prices. On the other hand we model the macroeconomic relationship between these two series through a complete open economy DSGE model. From the behavioral finance literature, investors may choose one of two rules to make their expectations. They maximize profits in both markets by solving a mean-variance problem that allows them to choose between a fundamental rule and a chartist one. An open economy general equilibrium model creates the fundamental expectations by reacting to the shocks coming from the financial markets. Through this macroeconomic structure, exchange rate shocks may influence stocks and viceversa. As a result, agents choose between different combinations of rules in the home equity market and in the foreign exchange market. The biggest new finding is that bubbles in one market may create values in the other that are similar to chartists bubbles, while following purely fundamentalist expectations. This dynamics is studied for different levels of pass-through between financial shocks and macroeconomic ones.
- Date:
- 2009
- Notes:
- Presented at SITE on August 14, 2009
- Title:
- Expectational Coordination in Simple Economic Contexts: Concepts and Analysis With Emphasis on Strategic Substitutabilities
- Author:
- Guesnerie, Roger and Jara-Moroni, Pedro
- Collector:
- Guesnerie, Roger and Jara-Moroni, Pedro
- Description:
- We consider an economic model that features: 1. a continuum of agents 2. an aggregate state of the world over which agents have an infinitesimal influence. We first review the connections between the "eductive viewpoint" that puts emphasis for example on "Strongly Rational Expectations equilibrium" and the standard game-theoretical rationalizability concepts. Besides the Cobweb tâtonnement outcomes, which mimic an "eductive" reasoning subject to homogenous expectations, we define, characterize (and prove the convexity of) the sets of "Rationalizable States" and "Point-Rationalizable States", which respectively incorporate heterogenous point-expectations and heterogenous stochastic expectations. In the case where our model displays strategic complementarities, we find unsurprisingly that all the ""eductive" criteria" under scrutiny support rather similar conclusions, particularly when the equilibrium is unique. With strategic susbstitutabilities, the success of expectational coordination, in the case where a unique equilibrium does exists, relates with the absence of cycles of order 2 of the "Cobweb" mapping : in this case, again, heterogenity of expectations does not matter. However, when cycles of order 2 do exist, our different criteria predict different set of outcomes, although all are tied with cycles of order 2. Under differentiability assumptions, the Poincaré-Hopf method leads to global results for Strong Rationality of equilibrium. At the local level, the different criteria under scrutiny can be adapted to the analysis of expectational coordination. They leads to the same stabilty conclusions, only when there are local strategic complementarities or strategic substitutabilities. However, so far as the analysis of local expectational coordination is concerned, it is argued and shown that the stochastic character of expectations can most often be forgotten.
- Date:
- 2009
- Notes:
- Presented at SITE on August 11, 2009
- Title:
- Financial Leverage and Market Volatility with Diverse Beliefs
- Author:
- Wu, Ho-Mou and Guo, Wen-Chung
- Collector:
- Wu, Ho-Mou and Guo, Wen-Chung
- Description:
- We develop a model of asset trading with financial leverage in an economy with a continuum of investors. The investors are assumed to have diverse and rational beliefs in the sense of being compatible with observed data. We show that a reduction in the margin requirement may cause the stock price to rise in the current period because it increases the demand of optimistic investors through a "leverage effect", and will result in "pyramiding" and "depyramiding" phenomena for stock prices in the subsequent period. Our results also suggest that a reduction in the margin requirement is anticipated to result in an increase in price volatility as well, however, under certain conditions. Price changes from pyramiding effect are also negatively associated with margin requirements. Price changes from depyramiding effect, however, may not be affected when margin calls are not triggered. Furthermore, the influences of dispersion of opinion, belief structure and investment funds are also examined.
- Date:
- 2009
- Notes:
- Presented at SITE on August 10, 2009
- Title:
- Further Discussion of Expectational Coordination Problems
- Author:
- Guesnerie, Roger
- Collector:
- Guesnerie, Roger
- Date:
- 2009
- Notes:
- Presented at SITE on August 14, 2009
- Title:
- Heterogeneous Expectations, Shock Amplification and Complex Dynamics in Competitive Business Cycle Models
- Author:
- McGough, Bruce and Branch, William
- Collector:
- McGough, Bruce and Branch, William
- Date:
- 2009
- Notes:
- Presented at SITE on August 12, 2009
- Title:
- Internal Rationality and Asset Prices
- Author:
- Adam, Klaus, Marcet, Albert, and Nicolini, Juan Pablo
- Collector:
- Adam, Klaus, Marcet, Albert, and Nicolini, Juan Pablo
- Description:
- We show how standard learning rules can be interpreted as small departures from rationality in the context of an asset pricing model. We propose a distinction between "internal rationality", as agents that maximize discounted expected utility under uncertainty given consistent beliefs about the future, and "external rationality" as agents that know perfectly the true stochastic process for fundamentals (dividends) and market determined variables (asset prices). Naturally, this distinction is irrelevant with complete markets and homogeneous agents. Yet, once one allows for weak forms of heterogeneity and market incompletness, the required amount of information and computational ability for achieving external rationality is gigantic. We also show how simple models of learning that satisfy internal rationality can be interpreted as small deviations from rationality.
- Date:
- 2009
- Notes:
- Presented at SITE on August 11, 2009
- Title:
- Learning, Hedging and the Natural Rate Hypothesis
- Author:
- Shea, Paul and Cone, Thomas E.
- Collector:
- Shea, Paul and Cone, Thomas E.
- Description:
- We assume that firms actively manage risk by learning and hedging in two macroeconomic models, a simple cobweb model and a model of monopolistic competition that allows for the analysis of monetary policy and welfare. In both models, firms that learn (by paying a cost to observe the model's stochastic shocks) face less uncertainty and produce more output than firms that hedge. Parameter or policy changes that increase the attractiveness of learning therefore induce a higher steady state level of output. When we introduce monetary policy into the latter model, we obtain three results that are profoundly different from all or most of the related literature. First, by affecting the volatility of the system, monetary policy affects the supply side decisions of producers and therefore affects the steady state level of output and not just its second moment. Second, if the fraction of firms that learn is exogenous, then the optimal policy maximizes steady state output and welfare by minimizing the volatility of the aggregate price level. Third, if the fraction of firms that learn is endogenous, then the optimal policy maximizes steady state output by ensuring an intermediate level of price stability, close to the minimum stability needed to induce the maximum amount of learning.
- Date:
- 2009
- Notes:
- Presented at SITE on August 10, 2009
- Title:
- Learning to Forecast the Exchange Rate: Two Competing Approaches
- Author:
- Markiewicz, Agnieszka and Grauwe, Paul De
- Collector:
- Markiewicz, Agnieszka and Grauwe, Paul De
- Description:
- In this paper we compare two competing approaches to model foreign exchange market participants behavior: statistical learning and fitness learning, applied to a set of predictors, which include chartists and fundamentalists. We examine which of these approaches is the best in terms of replicating the exchange rate dynamics within the framework of a standard asset pricing model. First, we find that both learning methods reveal the fundamental value of the exchange rate in the equilibrium. Second, we find that only fitness learning creates the disconnection phenomenon. None of the mechanisms is able to produce unit root process but both of them generate persistence in the volatility of exchange rate returns. These results suggest that fitness learning comes closer to replicate the foreign exchange market participants' behavior.
- Date:
- 2009
- Notes:
- Presented at SITE on August 14, 2009
- Title:
- Liquidity and Valuation in an Uncertain World
- Author:
- Easley, David and O'Hara, Maureen
- Collector:
- Easley, David and O'Hara, Maureen
- Description:
- During part of the 2007-2009 financial crisis there was little or no trade in a variety of financial assets, even though bids and asks existed for many of these assets. We develop a model in which this illiquidity arises from uncertainty, and we argue that this new form of illiquidity makes bid and ask prices unsuitable as metrics for establishing "fair value" for these assets. We show how the extreme uncertainty that traders face can be characterized by incomplete preferences over portfolios, and we use Bewley's [2002] model of decision making under uncertainty to derive equilibrium quotes and the non-existence of trade at these quotes. Having established the origin of the quotes, and why the market freezes, we are then able to use our approach to suggest alternatives for valuing assets in illiquid markets.
- Date:
- 2009
- Notes:
- Presented at SITE on August 10, 2009
- Title:
- Market Selection and Asset Prices
- Author:
- Blume, Larry and Easley, David
- Collector:
- Blume, Larry and Easley, David
- Description:
- In this chapter we survey asset pricing in dynamic economies with heterogeneous, rational traders. By ‘rational’ we mean traders whose decisions can be described by preference maximization, where preferences are restricted to those which have an subjective expected utility (SEU) representation. By ’heterogeneous” we mean SEU traders with different and distinct payoff functions, discount factors and beliefs about future prices which are not necessarily correct. We examine whether the market favors traders with particular characteristics through the redistribution of wealth, and the implications of wealth redistribution for asset pricing. The arguments we discuss on the issues of market selection and asset pricing in this somewhat limited domain have a broader applicability. We discuss selection dynamics on Gilboa-Schmeidler preferences and on arbitrarily specified investment and savings rules to see what discipline, if any, the market wealth-redistribution dynamic brings to this environment. We also clarify the relationship between the competing claims of the market selection analysis and the noise trader literature.
- Date:
- 2009
- Notes:
- Presented at SITE on August 11, 2009
- Title:
- Monetary Policy and Heterogeneous Expectations
- Author:
- Branch, William and Evans, George
- Collector:
- Branch, William and Evans, George
- Description:
- This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.
- Date:
- 2009
- Notes:
- Presented at SITE on August 12, 2009
- Title:
- On the Dynamics of Beliefs
- Author:
- Kurz, Mordecai
- Collector:
- Kurz, Mordecai
- Date:
- 2009
- Notes:
- Presented at SITE on August 11, 2009
- Title:
- Option Value of Cash
- Author:
- Yu, Jialin
- Collector:
- Yu, Jialin
- Description:
- This paper uses a dynamic model of heterogeneous beliefs (where investors agree to disagree) to study the positive price-volume correlation during a housing downturn. It shows: (i) beliefs may diverge, which prevents some pessimists from buying; (ii) in the case that beliefs cross (i.e., buyers become more optimistic than the sellers), home sales occur but are delayed due to the buyers' option to sell cash higher (using house as numeraire) if the downturn worsens. Such option to wait also has implications for the velocity of money during deflation, troubled assets in the crisis since 2007, IPO waves, and fire sales.
- Date:
- 2009
- Notes:
- Presented at SITE on August 10, 2009
- Title:
- Stabilizing, Pareto Improving Policies
- Author:
- Nielsen, Carsten Krabbe
- Collector:
- Nielsen, Carsten Krabbe
- Description:
- One of the objectives of the current policies of many central banks arguably is to stabilize economic activity. One possible justification for such a policy is that there is volatility in macro variables that individual agents cannot insure against. We study the simplest possible extension of the stochastic 2-period, one agent and one commodity OLG model, where we have added 1 more period, with only one potential activity, namely trading of contingent commodities. We assume, however, that markets are incomplete. In this case the monetary equilibrium is not Pareto Optimal and for an open set of economies an allocation where fluctuations in realized savings are removed, Pareto dominates the monetary equilibrium. This allocation may be implemented by means of a monetary/fiscal policy. The policy considered has a simple rationale, namely that it removes some of the uncertainty that agents face by reducing price, i.e interest rate volatility. We consider two fundamental sources of such volatility, namely respectively an objective and a subjective signal about the distribution of future endowments. The first case is when agents have Rational Expectations while the second case is studied in the context of agents having Rational Beliefs, beliefs which are consistent with empirical observations but not (necessarily) correct. In the context of rational beliefs, the uncertainty is about what beliefs future agents will hold, and we interpret this as being a consequence of diverse beliefs.
- Date:
- 2009
- Notes:
- Presented at SITE on August 12, 2009
- Title:
- Statistical Methods for Large Economies With Individual Risk: Malinvauds Model Revisited
- Author:
- Hammond, Peter
- Collector:
- Hammond, Peter
- Date:
- 2009
- Notes:
- Presented at SITE on August 13, 2009
- Title:
- The Diversity of Beliefs in Real Time: Estimates of Business Cycle Dynamics from Macroeconomic Models
- Author:
- Wieland, Volker
- Collector:
- Wieland, Volker
- Date:
- 2009
- Notes:
- Presented at SITE on August 12, 2009
- Title:
- What Moves Money Managers' Portfolios? An Investigation of Preferences and Beliefs
- Author:
- Aiolfi, Marco
- Collector:
- Aiolfi, Marco
- Description:
- Asset allocation is widely recognized as the most fundamental decision in the investment process. Surprisingly little work has been done on examining what drives the asset allocation recommendations of professional investment advisors. To address this issue, we propose a general framework to identify and estimate the parameters characterizing the preferences and beliefs of money managers. In a mean-variance framework, we provide joint estimates of the preference parameters and the beliefs conditioned on observable information that most closely reproduce the dynamics of the observed portfolio recommendations made by a panel of international money managers for The Economist. Our findings suggest that money managers behave as low riskaverse investors and that heterogeneity in their conditional beliefs is key to explaining differences in their recommended portfolio allocations. The source of heterogeneity lies in the diverse interpretation of publicly available information. Using our general framework, we cannot reject the hypothesis that, in general, money managers use information efficiently.
- Date:
- 2009
- Notes:
- Presented at SITE on August 13, 2009