“Confidence, Bond Risks, and Equity Returns,” July 2014.
Abstract: We show that investor confidence (size of ambiguity) about future consumption growth is driven by past consumption growth and inflation. While the effect of past consumption growth was always positive, the impact of inflation has moved considerably over time and switched on average from negative to positive in 1997. Motivated by this evidence, we develop and estimate a model in which the confidence process has discrete regime shifts, and find that the time-varying impacts of inflation on confidence enable the model to match the covariance between nominal bond and stock returns, which was slightly positive during 1970s, high during 1980s, and switched to negative in the past decade. The model can also account for stock and bond return predictability, correlation between price-dividend ratios and inflation, among others.
“Confidence, Asset Returns, and Monetary Policy in a New Keynesian Model,” December 2013.
Abstract: The volatility of macroeconomic and financial variables has exhibited a high degree of time variation in the data, and the conditional volatility of inflation is positively correlated with future volatility of other macroeconomic and financial variables. Instead of assuming exogenous stochastic volatility, this paper proposes a novel model that generates these features endogenously in a simple New Keynesian framework. The model can generate upward sloping yield curves and positive correlation between inflation and dividend yields. I assume that agents are ambiguity averse, and that the amount of ambiguity is affected by the past performance of the central bank. If the central bank was unable to control inflation and output recently, the agent becomes more ambiguous about technology growth and the ambiguity process becomes more volatile, thus (a) output, consumption, dividend yields, and stock returns fall, (b) risk free rate rises, and (c) the volatility rises. The first two effects imply an positive premium for long term bond relative to short term bond. Time-varying volatility in confidence implies time-varying volatility in macroeconomic and financial variables.
Work in Progress
“Portfolio Choice under Constant and Time Varying Ambiguity,” March 2012, Available upon request
Abstract: This paper examines a continuous time intertemporal consumption and portfolio choice problem under constant and time varying ambiguity. Time varying ambiguity reflect the fact investors’ confidence over the investment opportunities change over time. Investors with Chen and Epstein’s (2002) recursive multiple priors utility are uncertain about the mean of the underlying process. Under constant ambiguity and geometric brownian motion stock return process, there is no intertemporal hedging term in optimal portfolio. With time varying ambiguity, additional hedging term characterized by Malliavin derivatives and stochastic integrals appears in the optimal portfolio. Unlike all the previous works that the intertemporal hedging demand arise due to stochastic variation in investment opportunities, our hedging term arise from stochastic variation in ambiguity. And these two hedging term can be separated from each other.
“Central Bank Performance and Cross Country Stock Returns”