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APT-2: Preferences and Portfolios
Financial Innovation and Asset Prices
1INSEAD; 2EDHEC; 3Frankfurt School of Finance and Management
Our objective is to understand the effects of financial innovation on asset prices. The traditional view is that financial innovation improves the portfolio diversification of each investor and risk sharing across investors; thus, financial innovation should smooth consumption and reduce the volatility of the stochastic discount factor (SDF) leading to an increase in the price of the new asset and a decrease in its return volatility and risk premium. We show, however, that the traditional view depends crucially on the assumption of homogenous beliefs: when inexperienced investors are less well informed about the new asset class but rationally learn about it, many of these \intuitive" results are reversed: financial innovation can increase portfolio volatility, return volatility, and the risk premium, which decline to the pre-innovation level only slowly over time.
Tail Risk, Robust Portfolio Choice, and Asset Prices
1University of Warwick; 2Shanghai University of Finance and Economics
Equity jumps and consumption disasters exhibit slowly-decaying tail behavior admitting severe downside risk; moreover, heavy-tailed distributions governing these rare events are most challenging to estimate. This paper formulates and solves in closed form a portfolio choice problem in a multi-asset incomplete market characterized by ambiguous jumps. We find that, due to fear of tail incidents, an investor diminishes portfolio diversification, and more so under heavy-tailed jumps which intensify misspecification concerns. In the presence of jump ambiguity, calibration exercises show sizable wealth losses from underestimating tail risk and that heavy-tailed consumption disasters effectively help explain the variance premium and option prices.
Habits and Leverage
1Columbia University, NBER, CEPR; 2University of Chicago, NBER, CEPR
Many stylized facts of leverage, trading, and asset prices follow from a frictionless general equilibrium model that features agents’ heterogeneity in endowments and habit preferences. Our model predicts that aggregate debt increases in good times when stock prices are high, return volatility is low, and levered agents enjoy a “consumption boom.” Our model is consistent with poorer agents borrowing more and with recent evidence on intermediaries’ leverage being a priced factor of asset returns. In crisis times, levered agents strongly deleverage by “fire selling” their risky assets as asset prices drop. Yet, consistently with the data, their debt-to-wealth ratios increase because their wealth decline faster due to higher discount rates.
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Conference: EFA 2017
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