Options, the value of capital, and investment

Cover title.Includes bibliographical references (p. 21-22).Andrew B. Abel ... [et al.]

Equity Premia with Benchmark Levels of Consumption: Closed-Form Results

I calculate exact expressions for risk premia, term premia, and the premium on levered equity in a framework that includes habit formation, keeping/catching up with the Joneses, and possible departures from rational expectations. Closed-form expressions for the first and second moments of returns and for the R2 of a regression of stock returns on the dividend-price ratio are derived under lognormality for the case that includes keeping/catching up with the Joneses. Linear approximations illustrate how these moments of returns are affected by parameter values and illustrate quantitatively how well the model can account for values of the equity premium, the term premium, and the standard deviations of the riskless return and the rate of return on levered equity. For empirically relevant parameter values, the linear approximations yield values of the various moments that are close to those obtained from the exact solutions.

An Exploration of the Effects of Pessimism and Doubt on Asset Returns

The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is first-order stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The subjective distribution is characterized by doubt if it is mean-preserving spread of the objective distribution. Pessimism and doubt both reduce the riskfree rate and thus can help resolve the riskfree rate puzzle. Uniform pessimism and doubt both increase the average equity premium and thus can help resolve the equity premium puzzle.

Operative Gift and Bequest Motives

The Ricardian Equivalence Theorem, which is the proposition that changes in the timing of lump-sum taxes have no effect on assumption or capital accumulation, depends on the exist- of operative altruistic motives for intergenerational transfers. These transfers can be bequests from parents to children or gifts from children to parents. In order for the Ricardian Equivalence Theorem to hold, one of these transfer motives must be operative in the sense that the level of the transfer is not determined by a corner solution resulting from a binding non-negativity constraint This paper derives conditions that determine whether the bequest motive will be operative, the gift motive will be operative, or neither motive will be operative in a model in which consumers are altruistic toward their parents and their children.

A Stochastic Model of Investment, Marginal q and the Market Value of theFirm

This paper presents closed-form solutions for the investment and valuation of a competitive firm with a Cobb-Douglas production function and a constant elasticity adjustment cost function in the presence of stochastic prices for output and inputs. The value of the firm is a linear function of the capital stock. The optimal rate of investmentis an increasing function of the slope of the value function with respect to the capital stock (marginal q). A mean preserving spread of the distribution of future price increases investment. An increase in the scale of the random component of a price can increase, decrease or not affect the rate of investment depending on the sign of the covariance of this price with a weighted average of all prices.

Will bequests attenuate the predicted meltdown in stock prices when baby boomers retire?

Jim Poterba finds that consumers do not spend all of their assets during retirement, and he projects that the demand for assets will remain high when the baby boomers retire. Based on his forecast of continued high demand for capital, Poterba rejects the asset market meltdown hypothesis, which predicts a fall in stock prices when the baby boomers retire. ; The author develops a rational expectations general equilibrium model with a bequest motive and an aggregate supply curve for capital. In this model, a baby boom generates an increase in stock prices, and stock prices are rationally anticipated to fall when the baby boomers retire, even though, as emphasized by Poterba, consumers do not spend all of their assets during retirement. This finding contradicts Poterba's conclusion that continued high demand for assets by retired baby boomers will prevent a fall in the price of capital.Stock - Prices ; Retirement

Aggregate Savings in the Presence of Private and Social Insurance

In the presence of uncertain lifetimes, social security has the characteristics of an annuity: a consumer pays a tax when young in exchange for receiving a social security benefit if he survives to be old. If consumers have identical ex ante mortality probabilities, then a fully funded social security system would offer a rate of return equal to the actuarially fair rate available on competitively supplied private annuities. In this case fully funded social security would be a redundant asset and would have no effect on consumption or national saving. In this paper, consumers have different (publicly known) ex antemortality probabilities and consequently can buy actuarially fair private annuities offering different rates of return. If the social security system does not discriminate on the basis of ex ante mortality probabilities, then the introduction of social security induces a redistribution of income from consumers with a high probability of dying young to consumers with a low probability of dying young. Under homothetic utility this redistribution reduces aggregate bequests and aggregate consumption of young consumers in the steady state; the steady state national capital stock can either increase or decrease. If consumers display at least as much risk a version as the logarithmic utility function, then average steady state welfare is increased by the introduction of fully funded social security.

An exploration of the effects of pessimism and doubt on asset returns.

The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is first-order stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The subjective distribution is characterized by doubt if it is mean-preserving spread of the objective distribution. Pessimism and doubt both reduce the riskfree rate and thus can help resolve the riskfree rate puzzle. Uniform pessimism and doubt both increase the average equity premium and thus can help resolve the equity premium puzzle.Asset pricing ; Rational expectations (Economic theory)