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NBIM-1: Risk and the Macroeconomy
Mind the Gap: An Empirical Foundation for Investment-Based Asset Pricing Models
1Cornerstone Research; 2Arizona State University; 3University of Lausanne
Investment-based asset pricing models get traction from a common tenet, namely firms' limited flexibility in adjusting their physical capital. While this inflexibility mechanism is at the core of the investment-based approach, direct empirical evidence supporting this channel is scarce. We provide an empirical foundation for the inflexibility mechanism. We propose a standard modeling framework where firms optimally invest by closing a fraction of the gap between their existing capital stock and a target level of capital. Inflexible firms are sluggish in filling the gap, are more risky, and earn higher expected returns. We use sequential Bayesian techniques to estimate inflexibility and the gap for a large sample of US listed firms, and we test how they affect expected equity returns. Our evidence substantially corroborates the inflexibility mechanism as a first-order driver of cross-sectional differences in returns.
Show Me the Money: The Monetary Policy Risk Premium
1Federal Reserve Bank of Boston; 2Federal Reserve Bank of Richmond
This paper studies the effect of monetary policy on the cross-section of expected stock returns. We create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that are theoretically linked to how stocks react to monetary policy. We find that stocks whose prices react more positively to expansionary monetary policy surprises, high-MPE stocks, earn lower average returns. This finding is consistent with the intuition that monetary policy is expansionary in times of poor economic conditions when the marginal value of wealth is high, and thus high-MPE stocks serve as a hedge against such periods. A long-short trading strategy designed to exploit this effect achieves an annualized value-weighted return of 9.96% with an associated Sharpe Ratio of 0.93. This return premium cannot be explained by standard factor models and survives a battery of robustness tests.
Government Debt and Risk Premia
University of Pennsylvania
I document that government debt is related to risk premia in various asset markets: (i) the debt-to-GDP ratio positively predicts excess stock returns with out-of-sample R-squared up to 30% at a five-year horizon, outperforming many popular predictors; (ii) the debt-to-GDP ratio is positively correlated with credit risk premia in both corporate bond excess returns and yield spreads; (iii) higher debt-to-GDP ratio is associated with lower real risk-free rates, (iv) higher debt-to-GDP ratio corresponds to lower average expected returns on government debt; (v) debt-to-GDP ratio positively comoves with fiscal policy uncertainty. I rationalize these empirical findings in a general equilibrium model featuring recursive preferences, endogenous growth, distortionary taxation, and time-varying fiscal uncertainty. In the model, the tax risk premium is sizable and its time variation is driven by fiscal uncertainty. Furthermore, the model generates an endogenous relationship between the debt-to-GDP ratio and fiscal uncertainty. Fiscal uncertainty increases debt valuation through lower government discount rate. This mechanism is reinforced as higher debt conversely raises uncertainty in future fiscal consolidations.
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Conference: EFA 2017
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