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39
Labor income and predictable stock returns
 Review of Financial Studies
, 2006
"... We propose and test a novel economic mechanism that generates stock return predictability on both the time series and the cross section. In our model, investors’ income has two sources, wages and dividends, that grow stochastically over time. As a consequence, the fraction of total income produced b ..."
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Cited by 90 (2 self)
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We propose and test a novel economic mechanism that generates stock return predictability on both the time series and the cross section. In our model, investors’ income has two sources, wages and dividends, that grow stochastically over time. As a consequence, the fraction of total income produced by wages changes over time depending on economic conditions. We show that as this fraction fluctuates, the risk premium that investors require to hold stocks varies as well. We test the main implications of the model and find substantial support for it. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and adjusted R 2 ’s that are larger than those generated when using the dividend price ratio. Tests of the cross sectional implication find considerable improvements on the performance of both the conditional CAPM and CCAPM when compared to their unconditional counterparts.
HabitBased Explanation of the Exchange Rate Risk Premium
, 2005
"... This paper presents a fully rational general equilibrium model that produces a timevarying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this twocountry model, agents are characterized by slowmoving external habit preferences derived from Campbell & ..."
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Cited by 67 (5 self)
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This paper presents a fully rational general equilibrium model that produces a timevarying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this twocountry model, agents are characterized by slowmoving external habit preferences derived from Campbell & Cochrane (1999). Endowment shocks are i.i.d and real riskfree rates are timevarying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more riskaverse than her foreign counterpart. Times of high riskaversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberglike trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor.
Carry trades and currency crashes
 in D. Acemoglu, K. Rogoff & M. Woodford, eds, ‘NBER Macroeconomics Annual 2008
, 2008
"... This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between highinterestrate and lowinterestrate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which ..."
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Cited by 58 (10 self)
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This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between highinterestrate and lowinterestrate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interestrate puzzle. Carrytrade losses reduce future crash risk, but increase the price of crash risk. We also document excess comovement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
TimeVarying Risk, Interest Rates, and Exchange Rates in General Equilibrium
, 2005
"... Timevarying risk is the primary force driving nominal interest rate differentials on currencydenominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. We show that a general equilibrium monetary model with an endogenous source of risk vari ..."
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Cited by 46 (5 self)
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Timevarying risk is the primary force driving nominal interest rate differentials on currencydenominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. We show that a general equilibrium monetary model with an endogenous source of risk variation–a variable degree of asset market segmentation–can produce key features of actual interest rates and exchange rates. The endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, the benefit ofassetmarketparticipation varies, and that changes the fraction of agents participating. These effects lead the risk premium to vary systematically with the level of inflation. Our model produces variation in the risk premium even though the fundamental shocks have constant conditional variances.
Risks for the long run and the real exchange rate
 Journal of Political Economy
"... Brandt, Cochrane, and SantaClara (2004) pointed out that the implicit stochastic discount factors computed using prices, on the one hand, and consumption growth, on the other hand, have very different implications for their cross country correlation. They leave this as an unresolved puzzle. We ex ..."
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Cited by 25 (3 self)
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Brandt, Cochrane, and SantaClara (2004) pointed out that the implicit stochastic discount factors computed using prices, on the one hand, and consumption growth, on the other hand, have very different implications for their cross country correlation. They leave this as an unresolved puzzle. We explain it by combining Epstein and Zin (1989) preferences with a model of predictable returns and by positing a very correlated long run component. We also assume that the intertemporal elasticity of substitution is larger than one. This setup brings the stochastic discount factors computed using prices and quantities close together, by keeping the volatility of the depreciation rate in the order of 12 % and the cross country correlation of consumption growth around 30%.
Exchange Rate Volatility and the Forward Premium Anomaly,” 2006. Working Paper
"... Existing research has yet to identify a risk premium that accounts for important empirical properties of exchange rate returns such as the forward premium anomaly: the tendency for currencies with high interest rates to appreciate against currencies with lower interest rates. This paper examines the ..."
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Cited by 17 (2 self)
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Existing research has yet to identify a risk premium that accounts for important empirical properties of exchange rate returns such as the forward premium anomaly: the tendency for currencies with high interest rates to appreciate against currencies with lower interest rates. This paper examines the forward premium anomaly through the lens of an arbitragefree pricing model for the exchange rate and term structure of interest rates in two currencies. Previous papers in this literature have failed to match exchange rate volatility, which is a vital component of the risk premium in exchange rate returns. The model in this paper generalizes previous models and is estimated using the joint timeseries of U.S. and U.K. swap rates, dollar/pound exchange rate returns, and prices of atthemoney exchange rate options. I include option prices because they are highly sensitive to the level of volatility and to the pricing of volatility risk. When options are used to estimate the model, it successfully captures both exchange rate volatility and the term structure of interest rates in the U.S. and U.K. Using simulated data, I show that the model also replicates the empirical findings in Fama (1984) and accounts for the forward premium anomaly.
Common Risk Factors in Currency Markets
, 2008
"... Currency excess returns are highly predictable and strongly countercyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. A single returnbased factor, the return on t ..."
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Cited by 15 (0 self)
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Currency excess returns are highly predictable and strongly countercyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. A single returnbased factor, the return on the highest minus the return on the lowest interest rate currency portfolios, explains the crosssectional variation in average currency excess returns from low to high interest rate currencies. In a simple affine pricing model, we show that the highminuslow currency return measures that component of the stochastic discount factor innovations that is common across countries. To match the carry trade returns in the data, low interest rate currencies need to load more on this common innovation when the market price of global risk is high.
CrashNeutral Currency Carry Trades
, 2008
"... Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (19902008). Using data on foreign exchange options, this paper investigate ..."
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Cited by 13 (1 self)
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Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (19902008). Using data on foreign exchange options, this paper investigates whether these returns represent compensation for exposure to currency crashes. After eliminating net dollar exposure and hedging crash risk, excess returns to crashneutral currency carry trades are statistically indistinguishable from zero; returns to nondollarneutral portfolios remain positive, but are only weakly significant. The choice of option maturity has a significant impact on the realized excess returns, with quarterly hedging producing annualized returns that are 12 % higher than those obtained from monthly hedging.
Productionbased measures of risk for asset pricing
 Journal of Monetary Economics
, 2010
"... A stochastic discount factor for asset returns is recovered from equilibrium marginal rates of transformation of output across states of nature, inferred from the producers’ first order conditions. The marginal rate of transformation implies a novel macrofactor asset pricing model that does a reason ..."
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Cited by 13 (3 self)
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A stochastic discount factor for asset returns is recovered from equilibrium marginal rates of transformation of output across states of nature, inferred from the producers’ first order conditions. The marginal rate of transformation implies a novel macrofactor asset pricing model that does a reasonable job explaining the cross section of stock returns with plausible parameter values. Using a flexible representation of the firms ’ production technology, the producers ’ ability to transform output across states of nature is estimated to be high, in contrast with what is typically assumed in standard aggregate representations of the firms ’ production technology.
Global Currency Hedging
, 2006
"... This paper considers the risk management problem of an investor who holds a diversified portfolio of global equities and chooses long or short positions in currencies to manage the risk of the equity portfolio. Over the period 19752005, we find that the Australian dollar, Canadian dollar, Japanese ..."
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Cited by 11 (0 self)
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This paper considers the risk management problem of an investor who holds a diversified portfolio of global equities and chooses long or short positions in currencies to manage the risk of the equity portfolio. Over the period 19752005, we find that the Australian dollar, Canadian dollar, Japanese yen, and British pound are positively correlated with their domestic stock markets and with the global equity market, but the euro, the Swiss franc, and especially the US dollar are negatively correlated with global equities. These correlations imply that riskminimizing global investors should short the Australian and Canadian dollars, yen, and pound but should hold long positions in the US dollar, the euro, and the Swiss franc. Accordingly, US investors should overhedge foreign equity positions except those in euro countries, which should only be partially hedged. These conclusions are robust to variations in the investment horizon. In the past 15 years the negative equity correlation of the dollar appears to have weakened slightly, while that of the euro has strengthened.