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APT-2: New Models in Macro-Finance
Endogenous Price War Risks
1The Wharton School, University of Pennsylvania, United States of America; 2Hong Kong University of Science and Technology; 3Texas A&M University
We develop a general-equilibrium asset pricing model incorporating dynamic supergames of price competition. Price war risks can rise endogenously due to declines in long-run growth, because firms become effectively more impatient for cash flows and their incentives to undercut prices are stronger. The triggered price war risks amplify the initial shocks in long-run growth by narrowing profit margins and discouraging customer base development. In the industries with higher capacities of radical innovation, incentives of price undercutting are less responsive to persistent growth shocks, and thus firms are more immune to price war risks and long-run risks. Exploiting detailed patent, product price, brand-perception survey, and Factiva news data, we find evidence for price war risks, which are significantly priced. Our results shed new light on how long-run risks are priced in time series and cross section through the forward-looking industry competition.
Asset Pricing with Fading Memory
1University of Chicago; 2University of Michigan
Building on recent evidence that lifetime experiences shape individuals’ macroeconomic expectations, we study asset prices in an economy in which a representative agent learns with fading memory from experienced endowment growth. The agent updates subjective beliefs with constant gain, which induces memory loss, but is otherwise Bayesian in evaluating uncertainty. The model produces perpetual learning, substantial priced long-run growth rate uncertainty, and, conveniently, a stationary economy. This approach resolves many asset pricing puzzles and it reconciles model-implied subjective belief dynamics with survey data on individual investor return expectations within a simple setting with IID endowment growth, constant risk aversion, and a gain parameter calibrated to microdata estimates. The objective equity premium is high and strongly counter-cyclical in the sense of being negatively related to experienced stock market payout growth (a long-run weighted average of past growth rates). In contrast, the subjective equity premium is slightly pro-cyclical. As a consequence, subjective expectations errors are predictable and negatively related to past experienced payout growth. Consistent with this theory, we show empirically that experienced payout growth is negatively related to future stock market excess returns. Based on expectations data from individual investor surveys spanning several decades, we show that this measure of experienced growth is also strongly negatively related to subjective expectations errors.
Time-varying state variable risk premia in an ICAPM
1Nova School of Business and Economics, Portugal; 2University of New South Wales; 3ESCP Europe, France
We find that the relation between state variables, such as the t-bill rate and term spread, and consumption growth is time-varying. Cross-sectional risk premia for these state variables vary over time accordingly. When a state variable predicts consumption growth strongly relative to its own history, its risk premium increases by 5% (annualized). This effect is magnified by time-variation in the variance of state variables. These two drivers of common variation in risk premia are consistent with the conditional implications of an Intertemporal CAPM. This contributes to recent literature on the unconditional pricing of state variable risk that finds mixed results.