The implications of first-order risk aversion for asset market risk premiums

financial risk;international financial markets;capital asset pricing;excahnge rate;general equilibrium

Can Europe recover without credit?

Data from 135 countries covering five decades suggests that creditless recoveries, in which the stock of real credit does not return to the pre-crisis level for three years after the GDP trough, are not rare and are characterised by remarkable real GDP growth rates: 4.7 percent per year in middle-income countries and 3.2 percent per year in high-income countries. However, the implications of these historical episodes for the current European situation are limited, for two main reasons. First, creditless recoveries are much less common in highincome countries, than in low-income countries which are financially undeveloped. European economies heavily depend on bank loans and research suggests that loan supply played a major role in the recent weak credit performance of Europe. There are reasons to believe that, despite various efforts, normal lending has not yet been restored. Limited loan supply could be disruptive for the European economic recovery and there has been only a minor substitution of bank loans with debt securities. Second, creditless recoveries were associated with significant real exchange rate depreciation, which has hardly occurred so far in most of Europe. This stylised fact suggests that it might be difficult to re-establish economic growth in the absence of sizeable real exchange rate depreciation, if credit growth does not return

Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Models

A popular explanation of aggregate stock market behavior suggests that assets are priced as if there were a representative investor whose utility is a power function of the difference between aggregate consumption and a “habit” level, where the habit is some function of lagged and (possibly) contemporaneous consumption. But theory does not provide precise guidelines about the parametric functional relationship between the habit and aggregate consumption. This makes for- mal estimation and testing challenging; at the same time, it raises an empirical question about the functional form of the habit that best explains asset pricing data. This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. Our approach is to treat the functional form of the habit as unknown, and to estimate it along with the rest of the model’s finite dimensional parameters. This semiparametric approach allows us to empirically evaluate a number of interesting hypotheses about the specification of habit-based asset pricing models. Using stationary quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, the habit formation is internal, and the estimated time-preference parameter and the power utility parameter are sensible. In addition, our estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross-sectional stock return data. We find that an internal habit SDF proxy can explain a cross-section of size and book-market sorted portfolio equity returns better than (i) the Fama and French (1993) three-factor model, (ii) the Lettau and Ludvigson (2001b) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM

The Forward-Discount Puzzle in Central and Eastern Europe

This paper adds to evidence that the forward-discount puzzle is at least partly explained as a compensation for taking crash-risk. A number of Central and Eastern European exchange rates are compared. A Hidden Markov Model is used to identify two regimes for most of the exchange rates. These two regimes can be characterised as being either periods of stability or periods of instability. The level of international risk aversion and changes in US interest rates affect the probability of switching from one regime to the other. This model is then used to assess the way that these two factors affect the probability of a currency crisis. While the Czech Republic, Hungary and Bulgaria are very sensitive to international financial conditions, Poland and Romania are relatively immune. JEL classifications: C24, F31, F32; Key words: Exchange rates, uncovered interest parity, foreign exchange risk discount, hidden-Markov model, carry-trad