Asset pricing.

• Author: Piazzesi, Monika
• Position: National Bureau of Economic Research - Conference news

The NBER's Asset Pricing Program was created in 1991. Today, it has more than 130 members who present and discuss their research findings at three annual meetings. These meetings take place in the Midwest in the spring, on the east coast in the summer, and on the west coast in the fall. It has been my honor to serve as Program Director for the past three years, which have been particularly interesting as the financial crisis has challenged some of the conventional wisdom about the workings of asset markets. During this time, the Program's members have produced an impressive collection of more than 300 NBER Working Papers.

This report focuses specifically on quantitative structural asset pricing models. In recent years, the AP members have been researching models that can provide unified explanations of a wide range of phenomena in financial markets. Even before the financial crisis, some of these models provided an important base for understanding financial institutions, frictions in financial markets (such as credit constraints), liquidity, investor heterogeneity, and the potential presence of investor irrationality in some markets. Of course, since the crisis, AP Program members have intensified their analysis of models with such features.

Understanding Returns on Average and over Time

A well-known stylized fact about financial markets is that average returns on stocks, long government bonds, and corporate bonds are higher than the return on short bonds. Why do investors demand high compensation for such investments? In a frictionless model with optimizing investors, there are two possible answers: either households are highly risk averse, or they perceive these investments to be very risky.

Another well-documented stylized fact is that the returns on certain long-short strategies are predictable: low current stock valuations relative to fundamentals (for example, dividends or earnings) tend to be followed by high subsequent returns. The returns on currency carry trades are predictable based on interest rate differentials. The carry trade involving only domestic bonds is predictable based on the slope of the term structure.

Why don't investors simply borrow and buy some more stocks when expected returns on stocks are high? An economic explanation of return predictability needs a mechanism that discourages investors from doing just that. If investors were to buy stocks in anticipation of high returns, then these purchases would drive up stock prices today, destroying return predictability.

There are two ways to discourage investors from buying in a frictionless setting with rational expectations. First, investors may be more risk averse in times when expected returns are high. In bad times, when stocks are trading at low prices, investors could be well aware that prices are likely to go up, but they may worry about taking on the extra risk associated with holding more stocks. Second, investors may be facing more risk in times when expected returns are high. During the financial crisis, for example, the Dow dropped below 7000, and still households did not want to buy more stocks. A plausible explanation is that they were worried about losing their jobs and preferred holding cash.

The early work on quantitative asset pricing asked whether models could explain one or maybe even a few of the above stylized facts in isolation. Over the last couple of years, the focus has been on whether the models can explain a wide variety of phenomena in financial markets simultaneously. This recent research has made important progress: we now have a much more consistent explanation of the size and time variation of risk premiums across different asset classes. By carefully documenting dimensions along which existing models don't perform as well, we also have made significant progress in understanding where the theory needs improvement.

Some of the analysis of financial market equilibrium is done in a frictionless setting, where standard optimization conditions ("Euler equations") describe household behavior, but there are many reasons to believe that these Euler equations do not hold. For example, rich households may have financial advisors who manage their money for them, in which case the advisors' incentives may play important roles. Or, frictions such as credit constraints may be preventing households from borrowing precisely when they need the extra cash. For example, during the financial crisis, it may have been harder to get a new car loan or mortgage. In that case, optimality conditions may lead to Euler inequalities. Finally, households may not have rational expectations. As a consequence, Euler equations may hold, but under beliefs that do not represent a rational assessment of past evidence. In particular, households may not be aware when expected returns on stocks are high, and so they have no reason to buy them. I describe recent work on models with such features later in this report.

Time-Varying Risk Aversion

John Y. Campbell and John H. Cochrane (1) develop a model in which investors have time-varying risk aversion. The key assumption in their model is that investors' utility functions depend on the past history of aggregate consumption, so they capture a "Catching up with the Joneses" motive. Investors are more risk averse in recessions, when their consumption is low relative to past aggregate consumption. They are less risk averse in booms, when their consumption is high, and so gambling feels less threatening. These countercyclical movements in risk aversion make investors want to be compensated more for holding risky assets (such as stocks) in recessions. Thus, the model generates expected returns that are high in recessions.

More recent papers have studied the performance of the Campbell-Cochrane model in other asset markets. Jessica Wachter (2) shows that a quantitative implementation of a model with time-varying risk aversion can simultaneously explain the predictability of stock returns (as in Campbell-Cochrane) and long-term government bonds. Her paper provides a unified...