I introduce bankruptcy into a complete markets model with a continuum of ex ante identical agents who have power utility. Shares in a Lucas tree serve as collateral. Bankruptcy gives rise to a second risk factor in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints. The risk is measured by one moment of the wealth distribution, which multiplies the standard Breeden-Lucas stochastic discount factor. The economy is said to experience a negative liquidity shock when this growth rate is high, a large fraction of agents faces severely binding solvency constraints and the trading volume is low in financial markets. The adjustment to the Breeden-Lucas stochastic discount factor induces time variation in equity, bond and currency risk premia that is consistent with the data.

Exploiting micro-level household consumption data, we show that long-run stockholder consumption risk captures cross-sectional variation in average stock returns, including the size and value premia. To generate a longer time-series we form factor-mimicking portfolios for stockholder consumption growth that perform at least as well as the Fama-French factors in asset pricing tests. The stockholder share of aggregate consumption also captures time-variation in stock and bond market returns that mirrors the dynamics of the aggregate consumption-to-wealth ratio. We interpret our findings under a model of recursive preferences and find that risk aversion as low as 5 is sufficient to match both the cross-sectional price of risk and the equity premium for the wealthiest stockholders.

When utility is non-separable in nondurable and durable consumption and the elasticity of substitution between the goods is high, marginal utility rises when durable consumption falls. The model explains both the cross-sectional variation in expected stock returns and the time variation in the equity premium. Small stocks and value stocks deliver relatively low returns during recessions when durable consumption falls, which explains their high average returns relative to big stocks and growth stocks. Stock returns are unexpectedly low at business-cycle troughs when durable consumption falls sharply, which explains the counter-cyclical variation in the equity premium.

In a model with multiple agents with different risk aversions facing margin constraints, we show how securities ’ required returns are characterized both by their beta and their margins. Negative shocks to fundamentals make margin constraints bind, lowering risk free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding liquidity crisis gives rise to a “basis, ” that is, a price gap between securities with identical cash-flows but different margins. In the time series, the basis depends on the shadow cost of capital which can be captured through the interest-rate spread between collateralized and uncollateralized loans, and, in the cross section, it depends on relative margins. We apply the model empirically to the CDS-bond basis and other deviations from the Law of One Price, and to evaluate the effects of unconventional monetary policy and lending facilities. We are grateful for helpful comments from Markus Brunnermeier, Xavier Gabaix, Andrei Shleifer,

We estimate a structural model of optimal life-cycle housing and consumption in the presence of realistic labor income and house price uncertainties. The model postulates constant elasticity of substitution between housing service and nonhousing consumption, and explicitly incorporates a house adjustment cost. Our estimation fits the crosssectional and time-series household wealth and housing profiles from the Panel Study of Income Dynamics quite well, and suggests an intra-temporal elasticity of substitution between housing and nonhousing consumption of 0.33 and a housing adjustment cost that amounts to about 15 percent of house value. Policy experiments with estimated preference parameters imply that households respond nonlinearly to house price changes with large house price declines leading to sizable decreases in both the aggregate homeownership rate and aggregate non-housing consumption. The average marginal propensity to consume out of housing wealth changes ranges from 0.4 percent to 6 percent. When lending conditions are tightened in the form of a higher down payment requirement, interestingly, large house price declines result in more severe drops in the aggregate homeownership rate but milder decreases in nonhousing consumption. Key Words: Life-cycle, housing adjustment costs, intratemporal substitution, methods of simulated moments

I use a putty-clay technology to explain several asset market facts. The key mechanism is as follows: a one percent increase in revenues leads to a more-than-one percent increase in profits, since labor costs don’t move one-for-one. This amplification is greater for plants with low productivity for which the average profit margin (revenue minus costs) is small. This “operating leverage ” effect implies that low productivity plants benefit disproportionately from business cycle booms. These plants have thus higher systematic risk and higher average returns. This model can help explain the empirical findings of Fama and French (1992), and more generally the sources of differences in market betas across firms. I obtain supporting evidence for the mechanism using firm- and industry-level data. The aggregate effect follows from trend growth: low-productivity plants outnumber high-productivity plants, making the aggregate stock market procyclical. I examine these aggregate implications and find that this model generates a volatile stock market return that predicts the business cycle.

Stephen Schaefer and seminar participants at the following conferences for useful comments: the AREUEA, the XXXVI EWGFM, the FMA European meeting, the SAET meetings in Vigo, and the SAFE center at the University of Verona. We are especially grateful to an anonymous referee for many suggestions that have greatly improved the paper. All remaining errors are our own.

The demand for durable goods is more cyclical than that for nondurable goods and services. Consequently, the cash flow and stock returns of durable-good producers are exposed to higher systematic risk. Using the NIPA input-output tables, we construct portfolios of durable-good, nondurable-good, and service producers. In the cross-section, a strategy that is long on durables and short on services earns a sizable risk premium. In the time series, a strategy that is long on durables and short on the market portfolio earns a countercyclical risk premium. We develop an equilibrium asset-pricing model that explains these empirical findings.

Conference draft: preliminary We show that equity returns, the term spread, and excess returns on a broad range of assets are positively correlated with future economic growth. The common tendency for excess returns to lead the business cycle suggests a macroeconomic factor in the cyclical behavior of asset returns. We construct an exchange economy that illustrates how this might work. Its important ingredients are recursive preferences, stochastic volatility in consumption growth, and dynamic interaction between volatility and growth.

We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with high-order cumulants: skewness, kurtosis, and so on. We show that high-order cumulants are quantitatively important in both representative-agent models with disasters and in a statistical pricing model estimated from equity index options. Option prices thus provide independent confirmation of the impact of extreme events on asset returns, but they imply a more modest distribution of them.