Our paper examines whether the well-documented failure of unsophisticated investors to rebalance their portfolios can help to explain the enormous counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, we set up a model in which CRRA-utility investors have heterogeneous trading technologies. In our model, a large mass of investors do not re-balance their portfolio shares in response to aggregate shocks, while a smaller mass of active investors adjust their portfolio each period to respond to changes in the investment opportunity set. We find that these intermittent re-balancers amplify the effect of aggregate shocks on the time variation in risk premia by a factor of three by forcing active traders to sell more shares in good times and buy more shares in bad times.

This paper examines how anticipated and frequently repeated shocks are absorbed in liquid financial markets. We show that Treasury security prices in the secondary market decrease significantly in the few days leading up to subsequent Treasury auctions and recover shortly after, despite the fact that both the exact time and amount of each auction are announced in advance. This price pattern implies a substantial issuance cost to the Treasury Department, estimated to be between 9 and 18 basis points of the auction size; for example, it amounts to over half a billion dollars for issuing Treasury notes alone in 2007. These results appear to be consistent with the hypothesis of dealers’ limited risk-bearing capacity and the imperfect capital mobility of end-investors (e.g., local and foreign governments, insurance companies, pension funds, etc.), highlighting the important role of market frictions even in the most liquid and important financial markets.

We show that the credit quality of corporate debt issuers deteriorates during credit booms, and that this deterioration forecasts low excess returns to corporate bondholders. The key insight is that changes in the pricing of credit risk disproportionately affect the financing costs faced by low quality firms, so the debt issuance of low quality firms is particularly useful for forecasting bond returns. We show that a significant decline in issuer quality is a more reliable signal of credit market overheating than rapid aggregate credit growth. We use these findings to investigate the forces driving time-variation in expected corporate bond returns.