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Risks for the long run: A potential resolution of asset pricing puzzles
 JOURNAL OF FINANCE
, 1994
"... We model consumption and dividend growth rates as containing (i) a small longrun predictable component and (ii) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin’s (1989) preferences, can explain ke ..."
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Cited by 348 (30 self)
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We model consumption and dividend growth rates as containing (i) a small longrun predictable component and (ii) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin’s (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better longrun growth prospects raise equity prices. The model can justify the equity premium, the riskfree rate, and the volatility of the market return, riskfree rate, and the pricedividend ratio. As in the data, dividend yields predict returns and the volatility of returns is timevarying.
Consumption Strikes Back?: Measuring Long Run Risk, Unpublished working paper
, 2006
"... We characterize and measure a longterm riskreturn tradeoff for the valuation of cash flows exposed to fluctuations in macroeconomic growth. This tradeoff features risk prices of cash flows that are realized far into the future but continue to be reflected in asset values. We apply this analysis ..."
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Cited by 107 (13 self)
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We characterize and measure a longterm riskreturn tradeoff for the valuation of cash flows exposed to fluctuations in macroeconomic growth. This tradeoff features risk prices of cash flows that are realized far into the future but continue to be reflected in asset values. We apply this analysis to claims on aggregate cash flows and to cash flows from value and growth portfolios by imputing values to the longrun dynamic responses of cash flows to macroeconomic shocks. We explore the sensitivity of our results to features of the economic valuation model and of the model cash flow dynamics. I.
2004): “Model specification and risk premiums: Evidence from futures options,” Working paper, Columbia University, forthcoming in Journal of Finance
"... There are two central issues in option pricing: selecting an appropriate model and quantifying the risk premiums of the various underlying factors. In this paper, we use the information in the crosssection of S&P futures options from 1987 to 2003 to examine these issues. We first test for the prese ..."
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Cited by 17 (2 self)
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There are two central issues in option pricing: selecting an appropriate model and quantifying the risk premiums of the various underlying factors. In this paper, we use the information in the crosssection of S&P futures options from 1987 to 2003 to examine these issues. We first test for the presence of jumps in volatility by analyzing the higher moment behavior of option implied variance. The option data provides strong evidence supporting the presence of jumps in volatility. In conjunction with previous results, this implies that stochastic volatility, jumps in returns and jumps in volatility are all important components. Next, we find strong crosssectional evidence in support of jumps in returns, and modest evidence for jumps in volatility. We find evidence for reasonable jump risk premiums, but do not find any evidence for a diffusive volatility risk premium. We also find strong evidence for time variation in thejumpriskpremiums.
Dynamic Asset Allocation with Ambiguous Return Predictability, working paper
, 2009
"... We study an investor’s optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor’s aversion to mode ..."
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Cited by 14 (2 self)
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We study an investor’s optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor’s aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is large for high and low values of the predictive variable. Unlike in the Bayesian framework, the hedging demand against model uncertainty may cause the investor’s stock allocations to first decrease sharply and then increase with his prior probability of the IID model, even when the expected stock return under the IID model is lower than under the predictability model. Adopting suboptimal investment strategies by ignoring model uncertainty can lead to sizable welfare costs.
Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle.” Working Paper
, 2010
"... Highinterestrate currencies tend to appreciate in the future relative to lowinterestrate currencies instead of depreciating as uncoveredinterestparity (UIP) predicts. I construct a model of exchangerate determination in which ambiguityaverse agents face a dynamic filtering problem featuring ..."
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Cited by 8 (0 self)
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Highinterestrate currencies tend to appreciate in the future relative to lowinterestrate currencies instead of depreciating as uncoveredinterestparity (UIP) predicts. I construct a model of exchangerate determination in which ambiguityaverse agents face a dynamic filtering problem featuring signals of uncertain precision. Solving a maxmin problem, agents act upon a worstcase signal precision and systematically underestimate the hidden state that controls payoffs. Thus, on average, agents next periods perceive positive innovations, which generates an upward reevaluation of the strategy’s profitability and implies expost departures from UIP. The model also produces predictable expectational errors, negative skewness and timeseries momentum for currency speculation payoffs.
Modeling the Long Run: Valuation in Dynamic Stochastic Economies
, 2008
"... I explore the equilibrium value implications of economic models that incorporate reactions to a stochastic environment. I propose a dynamic value decomposition (DVD) designed to distinguish components of an underlying economic model that influence values over long horizons from components that impac ..."
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Cited by 7 (4 self)
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I explore the equilibrium value implications of economic models that incorporate reactions to a stochastic environment. I propose a dynamic value decomposition (DVD) designed to distinguish components of an underlying economic model that influence values over long horizons from components that impact only the short run. To quantify the role of parameter sensitivity and to impute longterm risk prices, I develop an associated perturbation technique. Finally, I use DVD methods to study formally some example economies and to speculate about others. A DVD is enabled by constructing operators indexed by the elapsed time between the date of pricing and the date of the future payoff (i.e. the future realization of a consumption claim). Thus formulated, methods from applied mathematics permit me to characterize valuation behavior as the time between price determination and payoff realization becomes large. An outcome of this analysis is the construction of a multiplicative martingale component of a process that is used to represent valuation in a dynamic economy with stochastic growth. I contrast the differences in the applicability between this multiplicative martingale method and an additive martingale method familiar from time series analysis that is used to identify shocks with longrun economic consequences.
Consumption and saving under Knightian uncertainty,” manuscript
, 2003
"... This paper studies consumption/saving problem under Knightian uncertainty in a two period setting. The multiplepriors utility model is adopted. The effects of income uncertainty and capital uncertainty on optimal savings are analyzed by deriving closed form solutions. 1 ..."
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Cited by 7 (1 self)
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This paper studies consumption/saving problem under Knightian uncertainty in a two period setting. The multiplepriors utility model is adopted. The effects of income uncertainty and capital uncertainty on optimal savings are analyzed by deriving closed form solutions. 1
Examining Macroeconomic Models through the Lens of Asset Pricing ∗
, 2011
"... Dynamicstochasticequilibriummodelsofthemacroeconomyaredesignedtomatch the macro time series including impulse response functions. Since these models aim to be structural, they also have implications for asset pricing. To assess these implications, we explore asset pricing counterparts to impulse res ..."
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Cited by 5 (2 self)
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Dynamicstochasticequilibriummodelsofthemacroeconomyaredesignedtomatch the macro time series including impulse response functions. Since these models aim to be structural, they also have implications for asset pricing. To assess these implications, we explore asset pricing counterparts to impulse response functions. We use the resulting dynamic value decomposition (DVD) methods to quantify the exposures of macroeconomic cash flows to shocks over alternative investment horizons and the corresponding prices or compensations that investors must receive because of the exposure to such shocks. We build on the continuoustime methods developed in Hansen and Scheinkman (2010), Borovička et al. (2011) and Hansen (2011) by constructing discretetime shock elasticities that measure the sensitivity of cash flows and their prices to economic shocks including economic shocks featured in the empirical macroeconomics literature. By design, our methods are applicable to economic models that are nonlinear, including models with stochastic volatility. We illustrate our methods by analyzing the asset pricing model of Ai et al. (2010) with tangible and intangible capital.
Ambiguity, Learning, and Asset Returns
, 2007
"... We develop a consumptionbased assetpricing model in which the representative agent is ambiguous about the hidden state in consumption growth. He learns about the hidden state under ambiguity by observing past consumption data. His preferences are represented by the smooth ambiguity model axiomatiz ..."
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Cited by 5 (0 self)
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We develop a consumptionbased assetpricing model in which the representative agent is ambiguous about the hidden state in consumption growth. He learns about the hidden state under ambiguity by observing past consumption data. His preferences are represented by the smooth ambiguity model axiomatized by Klibanoff et al. (2005, 2006). Unlike the standard Bayesian theory, this utility model implies that the posterior of the hidden state and the conditional distribution of the consumption process given a state cannot be reduced to a predictive distribution. By calibrating the ambiguity aversion parameter, the subjective discount factor, and the risk aversion parameter (with the latter two values between zero and one), our model can match the first moments of the equity premium and riskfree rate found in the data. In addition, our model can generate a variety of dynamic asset pricing phenomena, including the procyclical variation of pricedividend ratios, the countercyclical variation of equity premia and equity volatility, and the mean reversion and long horizon predictability of excess returns.