Do Wealth Fluctuations Generate Time-varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation

We use data from the PSID to investigate how households' portfolio allocations change in response to wealth fluctuations. Persistent habits, consumption commitments, and subsistence levels can generate time-varying risk aversion with the consequence that when the level of liquid wealth changes, the proportion a household invests in risky assets should also change in the same direction. In contrast, our analysis shows that the share of liquid assets that households invest in risky assets is not affected by wealth changes. Instead, one of the major drivers of households' portfolio allocation seems to be inertia: households rebalance only very slowly following inflows and outflows or capital gains and losses.

Optimal Expectations

This paper introduces a tractable, structural model of subjective beliefs. Since agents that plan for the future care about expected future utility flows, current felicity can be increased by believing that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decision making, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the total well-being of an agent over time. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return of their investment and under diversify. In general equilibrium, agents’ prior beliefs are endogenously heterogeneous, leading to gambling. Second, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life. Third, in choosing when to undertake a single task with an uncertain cost, agents exhibit several features of procrastination, including regret, intertemporal preference, reversal, and a greater readiness to accept commitment.Expectations formation, beliefs, overconfidence, wishful thinking, procrastination, gambling

Optimal Expectations

This paper introduces a tractable, structural model of subjective beliefs. Since agents that plan for the future care about expected future utility flows, current felicity can be increased by believing that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decision making, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the total well-being of an agent over time. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return of their investment and underdiversify. In general equilibrium, agents' prior beliefs are endogenously heterogeneous, leading to gambling. Second, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life. Third, in choosing when to undertake a single task with an uncertain cost, agents exhibit several features of procrastination, including regret, intertemporal preference reversal, and a greater readiness to accept commitment.expectations formation, beliefs, overconfidence

Market Liquidity and Funding Liquidity

We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to "flight to quality", and (v) comoves with the market, and it provides new testable predictions.

Predatory Trading

This paper studies predatory trading: trading that induces and/or exploits other investors' need to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buy back the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader's crisis, and the crisis can spill over across traders and across markets.

Deciphering the Liquidity and Credit Crunch 2007-08

This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

Optimal Beliefs, Asset Prices, and the Preference for Skewed Returns

Human beings want to believe that good outcomes in the future are more likely, but also want to make good decisions that increase average outcomes in the future. We consider a general equilibrium model with complete markets and show that when investors hold beliefs that optimally balance these two incentives, portfolio holdings and asset prices match six observed patterns: (i) because the cost of biased beliefs are typically second-order, investors typically hold biased assessments of probabilities and so are not perfectly diversified according to objective metrics; (ii) because the costs of biased beliefs temper these biases, the utility costs of the lack of diversification are limited; (iii) because there is a complementarity between believing a state more likely and purchasing more of the asset that pays off in that state, investors over-invest in only one Arrow-Debreu security and smooth their consumption well across the remaining states; (iv) because different households can settle on different states to be optimistic about, optimal portfolios of ex ante identical investors can be heterogeneous; (v) because low-price and low-probability states are the cheapest states to buy consumption in, overoptimism about these states distorts consumption the least in the rest of the states, so that investors tend to overinvest in the most skewed securities; (vi) finally, because investors with optimal expectations have higher demand for more skewed assets, ceteris paribus, more skewed asset can have lower average returns.

Predatory short selling

Financial institutions may be vulnerable to predatory short selling. When the stock of a financial institution is shorted aggressively, leverage constraints imposed by short-term creditors can force the institution to liquidate long-term investments at fire sale prices. For financial institutions that are sufficiently close to their leverage constraints, predatory short selling equilibria co-exist with no-liquidation equilibria (the vulnerability region), or may even be the unique equilibrium outcome (the doomed region). Increased coordination among short sellers expands the doomed region, where liquidation is the unique equilibrium. Our model provides a potential justification for temporary restrictions of short selling for vulnerable institutions and can be used to assess recent empirical evidence on short-sale bans