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Creator: Alvarez, Fernando, 1964 and Jermann, Urban J. Series: Endogenous incompleteness Abstract: We study the asset pricing implications of a multiagent endowment economy where agents can default on debt. We build on the environment studied by Kocherlakota (1995) and Kehoe and Levine (1993). We present an equilibrium concept for an economy with complete markets and with endogenous solvency constraints. These solvency constraints prevent default, but at the cost of reduced risk sharing. We show that versions of the classical welfare theorems hold for this equilibrium definition. We characterize the pricing kernel, and compare it to the one for economies without participation constraints: interest rates are lower and risk premia depend on the covariance of the idiosyncratic and aggregate shocks. Keyword: Equilibrium, Default, Solvency constraints, Risk, Shocks, and Assets Subject: G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates and D50  General equilibrium and disequilibrium  General 
Creator: Martin, Vance, 1955 and Pagan, Adrian R. Series: Simulationbased inference in econometrics Abstract: Procedures for computing the parameters of a broad class of multifactor continuous time models of the term structure based on indirect estimation methods are proposed. The approach consists of simulating the unknown factors from a set of stochastic differential equations which are used to compute synthetic bond yields. The bond yields are calibrated with actual bond yields via an auxiliary model. The approach circumvents many of the difficulties associated with direct estimation of this class of models using maximum likelihood. In particular, the paper addresses the identification issues arising from singularities in the yields and spreads which tend not to be recognised in existing estimation procedures and thereby overcome potential misspecification problems inherrent in direct methods. Indirect estimates of single and multifactor models are computed and compared with the estimates based on existing estimation procedures. Keyword: Continous time models, Indirect estimation, Multifactor models, Term structure, Testing factor models, Stochastic differential equations, and Singularities Subject: C30  Multiple or simultaneous equation models  General, C51  Econometric modeling  Model construction and estimation, and G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates 
Creator: Ostroy, Joseph M. and Potter, Simon M. Series: Finance, fluctuations, and development Abstract: We formulate a representative consumer model of intertemporal resource reallocation in which fluctuations in equity prices contribute to the smoothing of consumption flows. Features of the model include (a) an incompletely observable stochastic process of productivity shocks leading to fluctuating confidence of beliefs and (b) technologies involving commitments of a resource good. These features are exploited to show that (1) equities are not a representative form of total wealth and (2) the valuation of currently active firms is not representative of the valuation of all firms. We examine the implications of (1) and (2) to argue that empirical findings for the volatility and 'value shortfall' of equity prices may be consistent with a frictionless representative consumer model having a low degree of riskaversion. Simulation of a calibrated version of the model for a riskneutral consumer shows that when the 'data' is analyzed according to current econometric procedures, it is found to exhibit volatility of the same order of magnitude as that found in the actual data, although the model contains no excess volatility. Keyword: Technological commitments, Equity premium, Uncertainty of beliefs, Excess volatility, and Value shortfall Subject: G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates, E44  Money and interest rates  Financial markets and the macroeconomy, G14  General financial markets  Information and market efficiency ; Event studies, and E13  General aggregative models  Neoclassical 
Creator: Jagannathan, Ravi. and Wang, Zhenyu. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Dept.) Number: 517 Abstract: In empirical studies of the CAPM, it is commonly assumed that (a) the return to the value weighted portfolio of all stocks is a reasonable proxy for the return on the market portfolio of all assets in the economy, and (b) betas of assets remain constant over time. Under these assumptions, Fama and French (1992) find that the relation between average return and beta is flat. We argue that these two auxiliary assumptions are not reasonable. We demonstrate that when these assumptions are relaxed, the empirical support for the CAPM is surprisingly strong. When human capital is also included in measuring wealth, the CAPM is able to explain 28 percent of the cross sectional variation in average returns in the 100 portfolios studied by Fama and French. When, in addition, betas are allowed to vary over the business cycle, the CAPM is able to explain 57 percent. More important, relative size does not explain what is left unexplained after taking sampling errors into account. Keyword: Capital and Stock prices Subject: G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates 
Creator: Aiyagari, S. Rao. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Dept.) Number: 518 Abstract: This paper is about a useful way of taking account of frictions in asset pricing and macroeconomics. I start by noting that complete frictionless markets models have a number of empirical deficiencies. Then I suggest an alternative class of models with incomplete markets and heterogenous agents which can also accommodate a variety of other frictions. These models are quantitatively attractive and computationally feasible and have the potential to overcome many or all of the empirical deficiencies of complete frictionless markets models. The incomplete markets model can also differ significantly from the complete frictionless markets model on some important policy questions. Keyword: Friction, Frictionless market model, Asset pricing, Macroeconomics, and Incomplete markets Subject: E13  General aggregative models  Neoclassical and G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates 
Creator: Jagannathan, Ravi. and Wang, Zhenyu. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Dept.) Number: 517 Abstract: In empirical studies of the CAPM, it is commonly assumed that (a) the return to the value weighted portfolio of all stocks is a reasonable proxy for the return on the market portfolio of all assets in the economy, and (b) betas of assets remain constant over time. Under these assumptions, Fama and French (1992) find that the relation between average return and beta is flat. We argue that these two auxiliary assumptions are not reasonable. We demonstrate that when these assumptions are relaxed, the empirical support for the CAPM is surprisingly strong. When human capital is also included in measuring wealth, the CAPM is able to explain 28 percent of the cross sectional variation in average returns in the 100 portfolios studied by Fama and French. When, in addition, betas are allowed to vary over the business cycle, the CAPM is able to explain 57 percent. More important, relative size does not explain what is left unexplained after taking sampling errors into account. Keyword: Capital and Stock prices Subject: G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates 
On the relation between the expected value and the volatility of the nominal excess return on stocks
Creator: Glosten, Lawrence R., Jagannathan, Ravi., and Runkle, David Edward. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Dept.) Number: 505 Abstract: Earlier researchers have found either no relation or a positive relation between the conditional expected return and the conditional variance of the monthly excess return on stocks when they used the standard GARCHM model. This is in contrast to the negative relation found when other approaches were used to model conditional variance. We show that the difference in the estimated relation arises because the standard GARCHM model is misspecified. When the standard model is modified allow for (i) the presence for seasonal patterns in volatility, (ii) positive and negative innovations to returns to having different impacts on conditional volatility, and (iii) nominal interest rates to affect conditional variance, we once again find support for a negative relation. Using the modified GARCHM model, we also show that there is little evidence to support the traditional view that conditional volatility is highly persistent. Also, positive unanticipated returns result in a downward revision of the conditional volatility whereas negative unanticipated returns result in an upward revision of conditional volatility of a similar magnitude. Hence the time series properties of the monthly excess return on stocks appear to be substantially different from that of the daily excess return on stocks. Keyword: Asset valuation, Return rate, Risk, Rate of return, Stocks, and Stock market Subject: G11  General financial markets  Portfolio choice ; Investment decisions and G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates 
Creator: Allen, Franklin, 1956 and Gale, Douglas. Series: Monetary theory and financial intermediation Abstract: Traditional theories of asset pricing assume there is complete market participation so all investors participate in all markets. In this case changes in preferences typically have only a small effect on asset prices and are not an important determinant of asset price volatility. However, there is considerable empirical evidence that most investors participate in a limited number of markets. We show that limited market participation can amplify the effect of changes in preferences so that an arbitrarily small degree of aggregate uncertainty in preferences can cause a large degree of price volatility. We also show that in addition to this equilibrium with limited participation and volatile asset prices, there may exist a Paretopreferred equilibrium with complete participation and less volatility. Subject: C58  Financial Econometrics and G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates 
Creator: Lacker, Jeffrey Malcolm. and Schreft, Stacey Lee Series: Monetary theory and financial intermediation Abstract: We describe a stochastic economic environment in which the mix of money and trade credit used as means of payment is endogenous. The economy has an infinite horizon, spatial separation and a creditrelated transaction cost, but no capital. We find that the equilibrium prices of arbitrary contingent claims to future currency differ from those from onegood cashinadvance models. This anomaly is directly related to the endogeneity of the mix of media of exchange used. In particular, nominal interest rates affect the riskfree real rate of return. The model also has implications for some longstanding issues in monetary policy and for time series analysis using money and trade credit. Subject: G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates and E42  Money and interest rates  Monetary systems ; Standards ; Regimes ; Government and the monetary system ; Payment systems 
Creator: Backus, David., Gregory, Alan., and Zin, Stanley E. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Dept.) Number: 429 Abstract: We compare the statistical properties of prices of U.S. treasury bills to those generated by a theoretical dynamic exchange economy with complete markets. We show that the model can account for neither the sign nor the magnitude of average risk premiums in forward prices and holdingperiod returns. The economy is also incapable of generating enough variation in risk premiums to account for rejections of the expectations hypothesis with treasury bill data. These conclusions add to the growing list of empirical deficiencies of the representative agent model of asset pricing. Keyword: Autoregressive heteroskedasticity, Holdingperiod returns, Expectations hypothesis, and Forward prices Subject: C61  Mathematical methods and programming  Optimization techniques ; Programming models ; Dynamic analysis and G12  General financial markets  Asset pricing ; Trading volume ; Bond interest rates