This study investigates whether market-wide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 % annually, adjusted for exposures to the market return as well as size, value, and momentum factors.

This paper presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than con- ventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility and time-varying expected returns.

In this article we construct a model in which a consumer’s utility depends on the consumption history We describe a general equilibrium framework similar to Cox, Ingersoll, and Ross (1985a). A simple example is then solved in closedform in this general equilibrium setting to rationalize the observed stickiness of the consumption series relative to the fluctuations in stock market wealth. The sample paths of consumption generated from this model imply lower variability in consumption growth rates compared to those generated by models with separable utilizations. We then present a partial equilibrium model similar to Merton (1969, 1971) and extend Merton’s results on optimal consumption and portfolio rules to accommodate nonseparability in preferences. Asset pricing implications of our framework are briefly explored. The idea that a given bundle of consumption goods will provide the same level of satisfaction at any date regardless of one’s past consumption experience is implicit in models that use time-separable utility functions to represent preferences. Separable utility functions have been the mainstay in much of the literature on asset pricing and optimal consumption and portfolio The results reported in this article were first presented at the EFA meetings in Bern, Switzerland, in 1985 [see Sundaresan (1984)]. Subsequently the article was presented at a number of universities and conferences. I thank the participants at those presentations for their feedback. I am especially thankful to Doug Breeden, Michael Brennan, John Cox, Chi-fu Huang, and Krishna Ramaswamy for their thoughtful comments and criticisms. I also thank Tong-sheng Sun for explaining the simulation procedure for stochastic differential equations and for his comments and suggestions. I am responsible for any remaining errors. Correspondence should be sent to Suresh M. Sundaresan, Graduate

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This paper theoretically explores the characteristics underpinning quadratic term structure models (QTSMs), which designate the yield on a bond as a quadratic function of underlying state variables. We develop a comprehensive QTSM, which is maximally exible and thus encompasses the features of several diverse models including the double square-root model of Longsta (1989), the univariate quadratic model of Beaglehole and Tenney (1992), and the Squared-Autoregressive-Independent-Variable Nominal Term Structure (SAINTS) model of Constantinides (1992). We document a complete classication of admissibility and empirical identication for the QTSM, and demonstrate that the QTSM can overcome limitations inherent in ane term structure models (ATSMs). Using the Ecient Method of Moments of Gallant and Tauchen (1996), we test the empirical performance of the model in determining bond prices and compare the performance to the ATSMs. The results of the goodness-of-t tests suggest that the QTSMs...

: This paper links the term structure to perceptions of monetary policy. Long-horizon forecasts of short rates required by no-arbitrage term structure models are heavily influenced by the endpoints, or limiting conditional forecasts, of the short rate process. Common assumptions that the short rate is mean-reverting or contains a unit root are shown to generate unrealistic yield predictions. Failures occur because these assumptions inadequately account for historical shifts in market perceptions of the policy target for inflation. This paper links endpoint shifts to agent learning about shifts in long-term policy goals. Shifting endpoints in short rate processes significantly improve yield predictions. Keywords: Expectations Hypothesis, changepoints, breakpoints, learning JEL classification: E43 a Federal Reserve Bank of Kansas City, 925 Grand Boulevard, Kansas City MO 64198, USA. b Faculty of Economics and Politics, University of Cambridge, Cambridge CB3 9DD, UK. We are grateful ...

We propose a reduced-form model where jumps-to-default are priced because they generate a market-wide jump in credit spreads. While this framework is consistent with a counterparty risk interpretation (e.g., Jarrow and Yu (2001)), it is most naturally interpreted as an updating of beliefs due to an unexpected event. Simple analytic solutions are obtained for the prices of risky debt regardless of the number of firms that share in the contagious response. As a special case, we show that the contagious response can be induced via a liquidity-shock, with no impact on actual default intensities. Empirically, we find that credit events of large firms generate a market wide increase in credit spreads and a significant ‘flight-to-quality ’ response in the Treasury market. A calibration argument suggests that the premium associated with jump-to-default risk for a typical investment grade firm has an upper bound of a few basis points per year, but that the risk premium for contagion-risk may be considerably larger.

The paper proposes an original class of models for the continuous time price process of a financial security with non-constant volatility. The idea is to define instantaneous volatility in terms of exponentially-weighted moments of historic log-price. The instantaneous volatility is therefore driven by the same stochastic factors as the price process, so that unlike many other models of non-constant volatility, it is not necessary to introduce additional sources of randomness. Thus the market is complete and there are unique, preference-independent options prices. We find a partial differential equation for the price of a European Call Option. Smiles and skews are found in the resulting plots of implied volatility. Keywords: Option pricing, stochastic volatility, complete markets, smiles. Acknowledgement. It is a pleasure to thank the referees of an earlier draft of this paper whose perceptive comments have resulted in many improvements. 1 Research supported in part by Record Treasu...

Recent work in statistical mechanics has developed new analytical and numerical techniques to solve coupled stochastic equations. This paper applies the very fast simulated re-annealing and path-integral methodologies to the estimation of the Brennan and Schwartz two-factor term structure model. It is shown that these methodologies can be utilized to estimate more complicated n-factor nonlinear models. 1. CURRENT MODELS OF TERM STRUCTURE The modern theory of term structure of interest rates is based on equilibrium and arbitrage models in which bond prices are determined in terms of a few state variables. The one-factor models of Cox, Ingersoll and Ross (CIR) [1-4], and the two-factor models of Brennan and Schwartz (BS) [5-9] have been instrumental in the development of the valuation of interest dependent securities. The assumptions of these models include: • Bond prices are functions of a number of state variables, one to several, that follow Markov processes. • Inv estors are rational and prefer more wealth to less wealth. • Inv estors have homogeneous expectations.

This paper provides the first rigorous assessment of the homeownership experiences of subprime borrowers. We consider homeowners who used subprime mortgages to buy their homes, and estimate how often these borrowers end up in foreclosure. In order to evaluate these issues, we analyze homeownership experiences in Massachusetts over the 1989–2007 period using a competing risks, proportional hazard framework. We present two main findings. First, homeownerships that begin with a subprime purchase mortgage end up in foreclosure almost 20 percent of the time, or more than 6 times as often as experiences that begin with prime purchase mortgages. Second, house price appreciation plays a dominant role in generating foreclosures. In fact, we attribute most of the dramatic rise in Massachusetts foreclosures during 2006 and 2007 to the decline in house prices that began in the summer of