Time Varying Risk, Peso Problem and Asset Pricing

The author uses a variety of approaches to examine how an environment in which risk premiums vary through time and/or small sample problems (peso problems) exist can be used to explain many asset pricing anomalies. Three separate projects focussing on financial markets are planned.

The first two projects primarily focus on the apparent predictability of (international) asset returns. In one project, joint with Robert Hodrick, the PI will investigate whether or not statistical inference problems can account for the predictability in exchange rate and bond markets. To work on the 'Expectations Hypothesis,' they will develop a novel methodology to estimate a statistical model imposing the non-linear Expectations Hypothesis null. This method can be used to examine alternative, potentially better behaved tests of the hypothesis, and eventually lead to improved statistical inference in other applications as well.

In a second project, joint with Steve Grenadier, the author provides a stochastic valuation model for bond and stock returns that integrates three different pricing traditions (term structure factor models, present value models, and consumption based asset pricing) in a tractable framework. An application of the general model examines the effect of changes in dividend growth uncertainty on equity prices, and investigates whether time-variation in this uncertainty can generate the asymmetric return volatility patterns that are observed in the data.

The third proposed project groups a number of studies focussing on regime-switching models, which constitute natural models to examine peso problems. Two studies focus on interest rate dynamics, including one study attempting to detect whether regime switches in interest rates are caused by regimes in (expected) inflation or by regimes in real rates. Another project focuses on the joint behavior of interest rates and exchange rates in the European Monetary System (EMS). The EMS constitutes a natural laboratory for the study of peso problems because of its many speculative crises and accompanying large interest rate and exchange rate movements. The author also applies regime switching models to equity markets to examine two puzzles in portfolio choice: the under-investment of investors in equity markets, and the under-investment in international assets -- the home bias. The PI postulates that these may be explained by a fear of market crashes, which is particularly acute when investors exhibit disappointment aversion. Finally, the author uses a novel structural break methodology in studying the market integration process in emerging markets.