"What Can We Learn from a Consumption Based Asset Pricing Model with Systemic Risk?”
JOB MARKET PAPER (Click here for paper.)
This paper uses the standard consumption based asset pricing model with endogenous stochastic discount factor (sdf). Maintaining arbitrary return distributions, I add inter firm systemic risk. In contrast to the case without systemic risk, the market and planner allocate capital di fferently. Potential systemic spillovers cause the planner to reduce investment in the risky firm. The market, modeled as a representative agent, does not just ignore the externality and invest as if there were none. Instead, systemic risk increases the market's investment in the systemically risky institution or industry, further increasing systemic risk. These additional welfare losses from distorted capital allocation, caused by the asset-pricing e ffects of systemic risk, appear to be signi ficant. I introduce bailout of the financial industry and fi nd it has a benefi cial direct e ffect and a distortion e ffect. An Arbitrage Pricing Theory (A.P.T.) version of the model has empirical potential for asset prices and systemic risk.
“How Much Can Regulation Lower Systemic Risk?”
Presented at the 2012 Financial Management Association Conference. (Click here for paper.)
To assess the effect of comprehensive regulatory changes on systemic risk in general, and CoVaR in particular, this paper estimates the impact of the extensive and coincident U.S. regulatory changes of 1993 on the CoVaR of commercial banks. Using difference-in-difference, investment banks not subject to the law are controls. The unique circumstances used here could be exploited to inform other risk/regulation questions. Use of a novel CoVaR measure allows econometric assessment of exogenous changes and estimation of CoVaR standard errors. With high power, no effect is found. This eliminates from possibility one of two formerly widely held beliefs: 1. That Prompt Corrective Action and concurrent regulation lowered systemic risk, or 2. That CoVaR measures systemic risk. Recent theory allows derivation of CoVaR in terms of an asset-pricing model, yielding two additive terms. Results show a problem with one of the terms. However, the other term clearly measures spillovers and is not present in most other measures.
“Types of Systemic Risk”
(Click here for summary of paper.)
I use an Arbitrage Pricing Theory factor model with systemic risk spillovers to distinguish between systematic and systemic risks. The model shows why systematic risk is so often mistaken as systemic risk, why systematic risk in the financial industry is important, and why it should be considered along with systemic risk in regulatory eff orts. The model is then used to delineate and outline the various types of risk relevant to systemic crises. This vocabulary can facilitate communication and research in systemic risk. Finally, return distributions with humps in the left-hand tail and correlated tails are found to be the implication of interfi rm systemic risk.
WORKS IN PROGRESS:
“Testing Tax Smoothing via Synthetic Securities” with Peter Berck and Jonathan Lipow
Changing the portfolio of the government by sale of state owned enterprises or the taking of explicit market positions, such as the short position in Bohn (1990), provides the equivalent of an investment opportunity not offered in the natural market for assets. Making the usual assumption that marginal deadweight loss equals the tax rate, we show that consumers benefit from tax smoothing by means of the government selling a real asset if and only if the consumers would benefit from selling a synthetic asset that has a price of the tax rate times the price of the real asset. We use the Fama-French (FF) asset pricing model with and without momentum to test the desirability of a government portfolio change. Overcoming the joint-test problem that the model is inaccurate, we find the FF 25 portfolio that is euclidean-closest to the synthetic asset in factor space. We use the alpha of this FF 25 portfolio as the alpha-zero point for our hypothesis test. This correction method could have other applications.
“Investing in Low Usage Costs”
Empirical literature has established that firms (consumers) often forgo investing in expensive capital equipment (durables) with low usage cost, foregoing high expected returns - even in the absence of credit constraints. This is the basis of unexplained phenomena ranging from cell phone contracts to the important “energy paradox” in environmental economics. Treating the upgrade as an asset purchase in a CCAPM model, and properly accounting for the fact that the investor is expecting to decrease usage in bad states of nature, then demanding a very high expected return from this (high beta) asset is reasonable. The business and consumer models have many testable predictions.
JOB MARKET PAPER