The Relationship Between Financial Risk Premia and Macroeconomic Volatility: Issues and Perspectives on the Run-Up to the Turmoil

This note sketches the issues that arise while interpreting the relation between macroeconomic volatility and financial risk premia from the perspective of the standard consumption-based asset pricingmodel. The relation arises from the fact that all assets are priced by the same "pricingkernel", given by the inter-temporal marginal rate of substitution in consumption of the representative investor. Since the pricing kernel is a function of aggregate consumption, financial risk premia are positively related to consumption growth volatility. Therefore, from the perspective of this workhorse often employed in the academic debate, the persistent reduction in macroeconomic volatility can be considered a cause for the low average risk premia prevailing during the so-called Great Moderation, namely the period preceding the recent turmoil in financial markets. We challenge this view by shedding light on the issues that generate an inconsistent interpretation of the model outcomes. In particular, since the consumption-based model is geared towards asset prices consistent with macroeconomic fundamentals, we argue that it is not suited for interpreting current developments where underestimation of risk may have subsidized asset prices. In particular, according to the evidence for the Great Moderation, the model view suffers from observational equivalence.

Measuring market liquidity: An introductory survey

Asset liquidity in modern financial markets is a key but elusive concept. A market is often said to be liquid when the prevailing structure of transactions provides a prompt and secure link between the demand and supply of assets, thus delivering low costs of transaction. Providing a rigorous and empirically relevant definition of market liquidity has, however, provided to be a difficult task. This paper provides a critical review of the frameworks currently available for modelling and estimating the market liquidity of assets. We consider definitions that stress the role of the bid-ask spread and the estimation of its components that arise from alternative sources of market friction. In this case, intra-daily measures of liquidity appear relevant for capturing the core features of a market, and for their ability to describe the arrival of new information to market participants.