Long-run risks and financial markets

The recently developed long-run risks asset pricing model shows that concerns about long-run expected growth and time-varying uncertainty (i.e., volatility) about future economic prospects drive asset prices. These two channels of economic risks can account for the risk premia and asset price fluctuations. In addition, the model can empirically account for the cross-sectional differences in asset returns. Hence, the long-run risks model provides a coherent and systematic framework for analyzing financial markets.Financial markets ; Risk

Expropriation Risk and Return in Global Equity Markets

Standard asset pricing models have difficulty explaining cross-sectional differences in observed equity risk premia of developed and emerging markets. We argue that national equity returns are subject to sample selectivity. The lack of credible commitment to keep capital markets open (risk of expropriation) leads to this bias. We use the world CAPM for systematic risk and develop a model of sample selectivity. We find that after taking account of the sample selectivity bias, our model of systematic risk can account for the differences in risk premia quite well. We estimate the average expropriation risk to be more than ½ of the ex-post risk premium for emerging economies and close to zero for developed economies. Further, we argue that the measured selectivity bias in equity premia provide valuable economic information regarding the incentives for sovereigns not to expropriate international investors. We find that the measured expropriation risk is related to reputations in capital markets (as argued in Eaton and Gersowitz, 1981) and to the magnitude of trade that an economy conducts (as argued in Bulow and Rogoff, 1989a, 1989b).Sample Selectivity; Sovereign Risk; Peso Problem; World CAPM

Cointegration and Consumption Risks in Asset Returns

We argue that the cointegrating relation between dividends and consumption, a measure of long run consumption risks, is a key determinant of risk premia at all investment horizons. As the investment horizon increases, transitory risks disappear, and the asset's beta is dominated by long run consumption risks. We show that the return betas, derived from the cointegration-based VAR (EC-VAR) model, successfully account for the crosssectional variation in equity returns at both short and long horizons; this is not the case when the cointegrating restriction is ignored. Our evidence highlights the importance of cointegration-based long run consumption risks for financial markets.

Rational Pessimism, Rational Exuberance, and Asset Pricing Models

The paper estimates and examines the empirical plausibiltiy of asset pricing models that attempt to explain features of financial markets such as the size of the equity premium and the volatility of the stock market. In one model, the long run risks model of Bansal and Yaron (2004), low frequency movements and time varying uncertainty in aggregate consumption growth are the key channels for understanding asset prices. In another, as typified by Campbell and Cochrane (1999), habit formation, which generates time-varying risk-aversion and consequently time-variation in risk-premia, is the key channel. These models are fitted to data using simulation estimators. Both models are found to fit the data equally well at conventional significance levels, and they can track quite closely a new measure of realized annual volatility. Further scrutiny using a rich array of diagnostics suggests that the long run risk model is preferred.

Dynamic Trading Strategies and Portfolio Choice

Traditional mean-variance efficient portfolios do not capture the potential wealth creation opportunities provided by predictability of asset returns. We propose a simple method for constructing optimally managed portfolios that exploits the possibility that asset returns are predictable. We implement these portfolios in both single and multi-period horizon settings. We compare alternative portfolio strategies which include both buy-and-hold and fixed weight portfolios. We find that managed portfolios can significantly improve the mean-variance trade-off, in particular, for investors with investment horizons of three to five years. Also, in contrast to popular advice, we show that the buy-and-hold strategy should be avoided.Dynamic strategies; mean-variance optimization; multiperiod choice; efficient frontier; buy-and-hold investment

Dynamic Trading Strategies and Portfolio Choice

Traditional mean-variance efficient portfolios do not capture the potential wealth creation opportunities provided by predictability of asset returns. We propose a simple method for constructing optimally managed portfolios that exploits the possibility that asset returns are predictable. We implement these portfolios in both single and multi-period horizon settings. We compare alternative portfolio strategies which include both buy-and-hold and fixed weight portfolios. We find that managed portfolios can significantly improve the mean-variance trade-off, in particular, for investors with investment horizons of three to five years. Also, in contrast to popular advice, we show that the buy-and-hold strategy should be avoided.

Learning and Asset-Price Jumps

We develop a general equilibrium model in which income and dividends are smooth but asset prices contain large moves (jumps). These large price jumps are triggered by optimal decisions of investors to learn the unobserved state. We show that learning choice is determined by preference parameters and the conditional volatility of income process. An important model prediction is that income volatility predicts future jump periods, while income growth does not. Consistent with the model, large moves in returns in the data are predicted by consumption volatility but not by consumption growth. The model quantitatively captures these novel features of the data

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

We model dividend and consumption growth rates as containing a small long-run predictable component and economic uncertainty (i.e., growth rate volatility) as being time-varying. The magnitudes of the predictable variation and changing volatility in growth rates, as in the data, are quite small. These growth rate dynamics, for which we provide empirical support, in conjunction with plausible parameter configurations of the Epstein and Zin (1989) preferences can explain key observed asset markets phenomena. In particular, we show that the model can justify the observed equity premium, the low risk free rate, and the ex-post volatilities of the market return, real risk free rate, and the price-dividend ratio. As in the data, the model also implies that dividend yields predict returns and that market return volatility is stochastic. The main economic insight we capture is that news about growth rates significantly alter agent's perceptions regarding long run expected growth rates and growth rate uncertainty--in equilibrium, this leads to a large equity risk premium, low risk free interest rate, and large market volatility.

Temperature, Aggregate Risk, and Expected Returns

In this paper we show that temperature is an aggregate risk factor that adversely affects economic growth. Our argument is based on evidence from global capital markets which shows that the covariance between country equity returns and temperature (i.e., temperature betas) contains sharp information about the cross-country risk premium; countries closer to the Equator carry a positive temperature risk premium which decreases as one moves farther away from the Equator. The differences in temperature betas mirror exposures to aggregate growth rate risk, which we show is negatively impacted by temperature shocks. That is, portfolios with larger exposure to risk from aggregate growth also have larger temperature betas; hence, a larger risk premium. We further show that increases in global temperature have a negative impact on economic growth in countries closer to the Equator, while its impact is negligible in countries at high latitudes. Consistent with this evidence, we show that there is a parallel between a country's distance to the Equator and the economy's dependence on climate sensitive sectors; in countries closer to the Equator industries with a high exposure to temperature are more prevalent. We provide a Long-Run Risks based model that quantitatively accounts for cross-sectional differences in temperature betas, its link to expected returns, and the connection between aggregate growth and temperature risks.

Service Quality Assessment in Insurance Sector: A Comparative Study between Indian and Chinese Customers

Globalisation and open market system have created the complex competitive environment not only for the manufacturing sector but also for the service sector. Recent developments in global economy have led the service companies especially the insurance companies to plan and execute their strategies towards increasing customer satisfaction and loyalty through improved service quality. The present study focuses on developing a valid and reliable instrument to measure customer perceived service quality and comparing these between Indian and Chinese Insurance companies. The resulting validated instrument comprised of six dimensions: assurance, personalized financial planning, competence, corporate image, tangibles and technology. The study finds that although both the countries are operating in similar service environment but the responses to these service quality components differ from customers of one country to another. Keywords: Service Quality, Cross Cultural, Insurance, GAP analysis