Christian Heyerdahl-Larsen, BI Norwegian Business School
Philipp Illeditsch, Texas A&M University
Petra Sinagl, University of Iowa
Abstract: Recessions lead to substantial, yet not immediate drop in output. The low and often negative growth during recessions is typically followed by a steady recovery with abnormally high growth. We propose a theory where a recession is preceded by the introduction of a new risk source. The expected impact on economic growth of this new risk is negative and varies in terms of duration and severity. Consistent with the data, recovery is slow but characterized by higher than average output growth. We show that the expected path of both risk premia and return volatilities are hump-shaped at the start of a recession, that is, risk premia and return volatilities do not immediately rise which is in contrast to most asset-pricing models. We calibrate the model to the average economic recession and recovery and show that it quantitatively matches the unconditional asset pricing moments as well as asset pricing moments during recessions.
Discussant: Ram Yamarthy, Federal Reserve Board of Governors
Abstract: I present a consumption-based asset pricing model in which the representative agent selectively recalls past fundamentals that resemble current fundamentals and updates beliefs as if the recalled observations are all that occurred. This similarity-weighted selective memory jointly explains important facts about belief formation, survey data, and realized asset prices. Subjective expectations overreact and are procyclical, the subjective volatility is countercyclical, and the subjective risk premium has a low volatility. In contrast, realized returns are predictably countercyclical, highly volatile, and unrelated to variation of objective risk measures. My results suggest that human memory can simultaneously account for individual-level data and aggregate asset pricing facts.
Abstract: We study a dynamic equilibrium model in which investors disagree on future volatility and trade volatility derivatives to hedge stock positions and speculate. On average, volatility disagreement makes the variance risk premium more negative. However, volatility trading enables a risk transfer among investors that turns the variance risk premium positive when the market underestimates future volatility. Under higher volatility, investors trade fewer volatility derivatives as these become too risky. These economic mechanisms shed light on empirical regularities during market turmoil. Volatility disagreement also lowers the stock market valuation, increases market volatility, and generates time-variation in the leverage effect.
Discussant: Alberto Teguia, University of British Columbia
