Precautionary saving and asset pricing: implications of separating time and risk preferences

It is a topic of active research in consumer and capital theory to determine how to characterize preferences about uncertainty and intertemporal choice. Intertemporal extensions of expected utility theory produce serious theoretical and empirical difficulties in many economic modeling applications by artificially restricting the functional forms used to characterize risk attitude and intertemporal preference. An important consequence is that these two distinct preference concepts become indistinguishable within an expected utility index. Recent theoretical work has produced alternatives to expected utility which allow independent specification of functional forms and thus permit the separation of the two preference parameters. This study uses a simple two-period labor-leisure and consumption model which can distinguish between an absolute risk aversion parameter and the elasticity of intertemporal substitution to show the asymmetric way each parameter influences intertemporal factor allocation decisions, particularly precautionary saving behavior, under alternative stochastic income sources. Pure endowment, pure capital return, and pure wage income risk, as well as various combinations of them, are all addressed in the study, and for each case a set of closed-form comparative static decision rules is derived. It is shown that intertemporal preference plays a significant role in determining factor supply decisions when either the intertemporal price of consumption or leisure is affected by risk, while risk attitude dominates behavior when intertemporal preferences are assumed homothetic and both intertemporal prices remain undisturbed. It is also shown that possible income correlation can magnify, dampen, or even reverse the comparative static implications in the three univariate cases. Computer simulations are used to derive numerical solutions for the model which highlight these effects;These results are contrasted with those obtained from an isoelastic expected utility model which entangles the risk attitude and intertemporal preference parameters, and thus treats each symmetrically in motivating factor allocation decisions over time;This study also examines the usefulness of a popular class of recursive preferences developed by Epstein and Zin (1989, 1991) for asset pricing applications. This class of preferences also distinguishes between risk attitude and intertemporal preference, and has been shown in the received literature to improve upon the poor empirical performance of expected utility in consumption-based models of asset pricing. However, using the nonparametric test procedure of Hansen and Jagannathan (1991) as well as seasonally unadjusted US data, it is shown in this study that little improvement occurs when moving from expected utility to this recursive class of preferences, suggesting that the meshing of preferences in the former does not account for its inability to explain the high volatility of asset prices in the US. Thus, while the added analytical power derived by independently specifying preference functional forms can generate new theoretical insights, this freedom may have limited usefulness in other areas of economic research

Higher-moment stochastic discount factor specifications and the cross-section of asset returns

The stochastic discount factor model provides a general framework for pricing assets. A suitably specified discount factor encompasses most of the theories currently in use, including the CAPM, consumption CAPM, higher-moment CAPM and their conditional versions. In this thesis, we focus on the empirical admissibility of alternative SDFs under restrictions that ensure that investors’ risk-preferences are well behaved. More innovatively, we explore whether the SDF implied by the 3 and 4-moment CAPM is plausible under restrictions that are weaker than those considered by Dittmar (2002) yet sufficient to rule out implausible curvature of the representative investor’s utility functions. We find that, even under these weaker restrictions, the 3 and 4-moment CAPM cannot solve well known puzzles which plague the empirical performance of extant rational asset pricing models, even though the higher order terms do generate considerable additional explanatory power. Faced with this difficulty, we then explore whether the failure to fully account for cross-sectional differences in average returns can be explained by the presence of either transaction costs or a behavioural component of the SDF, reflecting investors’ systematic mistakes in processing information. We find evidence of both problems, though our analysis is not conclusive in this respect. Finally, in a more applied exercise, we apply the SDF-framework to test whether Chinese fund managers generate superior investment performance, and find that Chinese fund managers have not achieved better performance than the individual investors under either the unconditional or the conditional measure

Components of the Czech Koruna Risk Premium in a Multiple-Dealer FX Market

The paper proposes a continuous time model of an FX market organized as a multiple dealership. The model reflects a number of salient features of the Czech koruna spot market. The dealers have costly access to the best available quotes. They interpret signals from the joint dealer-customer order flow and decide upon their own quotes and trades in the inter-dealer market. Each dealer uses the observed order flow to improve the subjective estimates of the relevant aggregate variables, which are the sources of uncertainty. One of the risk factors is the size of the cross-border dealer transactions in the FX market. These uncertainties have diffusion form and are dealt with according to the principles of portfolio optimization in continuous time. The model is used to explain the country, or risk, premium in the uncovered national return parity equation for the koruna/euro exchange rate. The two country premium terms that I identify in excess of the usual covariance term (a consequence of the 'Jensen inequality effect') are the dealer heterogeneity-induced inter-dealer market order flow component and the dealer Bayesian learning component. As a result, a 'dealer-based total return parity' formula links the exchange rate to both the 'fundamental' factors represented by the differential of the national asset returns, and the microstructural factors represented by heterogeneous dealer knowledge of the aggregate order flow and the fundamentals. Evidence on the cross-border order flow dependence of the Czech koruna risk premium, in accordance with the model prediction, is documented.Bayesian learning, FX microstructure, optimizing dealer, uncovered parity.

Three essays on pricing kernel in asset pricing

Pricing Kernel extends concepts from economics and finance to include adjustments for risk. When pricing kernel is given, by non-arbitrage theory, all securities can be priced. Searching for a proper pricing kernel is one of the most important tasks for researchers in asset pricing. In this thesis, we attempt to search a proper pricing kernel in three different scenarios. In chapter 1, we attempt to find a robust pricing kernel for a stochastic volatility model with parameter uncertainty in an incomplete commodity market. Based on a class of stochastic volatility models in Trolle and Schwartz (2009), we investigate how the parameter uncertainty affects the risk premium and commodity contingent claim pricing. To answer this question, we follow a two-step procedure. Firstly, we propose a benchmark approach to find an optimal pricing kernel for the model without parameter uncertainty. Secondly, we uncover a robust pricing kernel via a robust approach for the model with parameter uncertainty. Thirdly, we apply the two pricing kernels into the commodity contingent claim pricing and quantify effect of parameter uncertainty on contingent claim securities. We find that the parameter uncertainty attributes a negative uncertainty risk premium. Moreover, the negative uncertainty risk premium yields a positive uncertainty volatility component in the implied volatilities in the option market. In chapter 2, we propose a multi-factor model with a quadratic pricing kernel, in which the underlying asset return is a linear function of multi-factors and the pricing kernel is a quadratic function of multi-factors. The model provides a potential unified framework to link cross sectional literatures, time-series literatures, option pricing literatures and term structure literatures. By examining option data from 2005 to 2008, this model dramatically improves the cross-sectional fitting of option data both in sample and out of sample than many standard GARCH volatility models such as Christoffersen, Heston and Nandi (2011). This model also offers explanations for several puzzles such as the U shape relationship between the pricing kernel and market index return, the implied volatility puzzle and fat tails of risk neutral return density function relative to the physical distribution. In chapter 3, we investigate whether idiosyncratic volatility risk premium is cross-sectional variant. We use stock historical moving average price as a proxy for retail ownership and examine whether idiosyncratic volatility is correlated with stock price level. Evidence from cross-sectional regressions and portfolio analysis both suggests that low-priced stocks (high retail ownership) have a significantly higher idiosyncratic volatility risk premium than high-priced stocks (low retail ownership). Especially, evidence in subsample tests suggests that lowest-priced stocks (highest retail ownership) have a significantly positive idiosyncratic risk premium while highest-priced stocks (lowest retail ownership) have an insignificant one, which is consistent with theoretical predictions of Merton (1986) and classical portfolio theory

Price change and trading volume in a speculative market

This thesis is concerned with the daily dynamics of price change and trading volume in a speculative market. The first part examines the news-driven model of Tauchen and Pitts (1983), and develops this model to the point where it is directly testable. In order to implement the test a new method for creating a price index from futures contracts is proposed. It is found that news effects can explain some but not all of the structure of the daily price/volume relationship. An alternative explanation is presented, in which the model of Tauchen and Pitts is generalized in a non-linear fashion. In the second part of the thesis, the presence of a small amount of positive autocorrelation in daily returns is exploited through the development of a timing rule. This timing rule applies to investors who are committed to a purchase but flexible about the precise timing. The computation of the timing rule is discussed in detail. In practice it is found that this timing rule is unlikely to generate sufficiently large returns to be of interest to investors in a typical stock market, supporting the hypothesis of market efficiency. However, the incorporation of extra information regarding price/volume dynamics, as suggested by the analysis of Part I, might lead to a much improved rule

Essays on robust asset pricing

The central concept of this doctoral dissertation is robustness. I analyze how model and parameter uncertainty affect financial decisions of investors and fund managers, and what their equilibrium consequences are. Chapter 1 gives an overview of the most important concepts and methodologies used in the robust asset allocation and robust asset pricing literature, and it also reviews the most recent advances thereof. Chapter 2 provides a resolution to the bond premium puzzle by featuring robust investors, and – as a technical contribution – it develops a novel technique to solve robust dynamic asset allocation problems: the robust version of the martingale method. Chapter 3 contributes to the resolution of the liquidity premium puzzle by demonstrating that parameter uncertainty generates an additional, positive liquidity premium component, the liquidity uncertainty premium. Chapter 4 examines the effects of model uncertainty on optimal Asset Liability Management decisions

Price and wealth dynamics in a speculative market with generic procedurally rational traders

An agent-based model of a simple financial market with arbitrary number of traders having relatively general behavioral specifications is analyzed. In a pure exchange economy with two assets, riskless and risky, trading takes place in discrete time under endogenous price formation setting. Traders’ demands for the risky asset are expressed as fractions of their individual wealths, so that the dynamical system in terms of wealth and return is obtained. Agents’ choices, i.e. investment fractions, are described by means of the generic smooth functions of an infinite information set. The choices can be consistent with (but not limited to) the solutions of the expected utility maximization problems. A complete characterization of equilibria is given. It is shown that irrespectively of the number of agents and of their behavior, all possible equilibria belong to a one-dimensional “Equilibrium Market Line”. This geometric tool helps to illustrate possibility of different phenomena, like multiple equilibria, and also can be used for comparative static analysis. The stability conditions of equilibria are derived for general model specification and allow to discuss the relative performances of different strategies and the selection principle governing market dynamics