Essays in Information-Based Asset Pricing

I started my Ph.D. studies in the Fall 2008, a period ex-post perceived as being at the core of the Financial Crisis. At that time my ideas were vague and I struggled to find a good research topic. As surprising as it might appear, in one single week the discussions I had with my relatives provided me with enough ideas needed to write my thesis. Indeed, during that single week my relatives contacted me and complained about the fact that they had lost money invested in the financial market. They wanted me to advise them. I simply told them to invest their money in relatively safe bonds. My relatives did not realize how fruitful their behavior was for me. Indeed, after having advised them I wondered whether their willingness to gather information in bad times was optimal or pure irrationality. This issue is addressed in the first chapter of my thesis. The last two chapters investigate the impact of the willingness to gather more information in bad times than in good times on the dynamics of asset prices. My thesis answers two very important questions: When should investors acquire information given that information-processing is costly and what is the impact of the optimal information acquisition strategy on asset price dynamics? Consequently, the main topic of my thesis is the transmission of acquired information in financial markets. In the first chapter I consider a dynamic portfolio choice and costly information acquisition problem. Consistent with my relatives behavior, I show that it is optimal to gather more information in bad times than in good times. As the state of the economy worsens, investors optimally re-balance their portfolio towards safer investment and spend more and more money to gather more and more accurate information regarding future market moves. This result derived in a purely rational setup helps to understand the empirical observation that people tend to pay fluctuating attention to news, focusing more in downturns than in upturns. To the best of my knowledge, this paper is the first to consider costly information acquisition in a dynamic setting. The main contribution is to provide insights on how investors should optimally allocate their wealth to the financial market on the one hand and to information market on the other hand given current market conditions. In the second chapter (with Daniel Andrei) we model the optimal information acquisition strategy obtained in the first chapter in a general equilibrium framework and we show that this strategy (fluctuating attention paid to news) has very interesting implications on the dynamics of asset prices. Our main contribution is to highlight a J-shaped relationship between attention and volatility. By constructing an empirical measure of attention to news, we show that the theoretical prediction of our model holds in the data. Moreover, we are the first to provide a theoretical foundation for the fact that the slope of the term structure of equity premia is pro-cyclical. In the third chapter I investigate the impact of fluctuating attention to news in a multi-asset general equilibrium framework. My main contribution is to show that fluctuating attention to news generates return and volatility spillover effects among financial markets. As a bad shock hits one market, investors raise their attention to that particular market. This implies a simultaneous increase in each market volatility and in each cross-market correlation, a phenomenon called financial contagion. Moreover, I document that the interconnection between attention and uncertainty generates persistence in cross-market correlations. This very interesting result proves that persistence can be generated through Bayesian learning. Finally, I am the first to provide a theoretical foundation for the observed shape of the term structure of correlation. Consistent with empirical findings, I show that fluctuating attention implies an upward sloping term structure of correlation where the shorthand is wider than the longhand.

Financial Stability and the Macroeconomy

Corinne Dubois

The financial crisis of 2007-2009 drew attention to the essential role of banks for the macroeconomy and to the importance of having a resilient financial sector. A vulnerability in the financial sector spills over to the real economy and can drive it into a deep recession. Following the financial crisis, policy makers have issued rules and regulations aimed at strengthening the banks. My dissertation considers some of those measures, namely bank liquidity regulation and deposit insurance, and tries to assess their effectiveness in stabilizing the financial sector and the economy in general. The first chapter (joint with Prof. Luisa Lambertini) develops a model with regulated banks and a hedge fund to analyze the behavior of wholesale funding and the macroeconomic consequences of liquidity regulation. Banks raise deposits and subordinated wholesale funding from the hedge fund. Wholesale funding amplifies shocks: it is curtailed in economic downturns to avoid leveraging up and risk-taking by banks, further depressing credit and economic activity. By making banks safer, liquidity regulation increases wholesale funding and bank loans at the steady state. However, flat liquidity regulation requiring banks to hold a constant fraction of liquid assets can have unintended consequences and increase macroeconomic volatility. Our model further shows that cyclically adjusted regulation stabilizes the response of the economy to shocks. We also provide empirical evidence suggesting that liquidity helps contain the contraction in wholesale funding and loans during times of funding stress. The second chapter explores the macroeconomic and welfare implications of harmonizing or joining deposit insurance in the Eurozone. I develop a two-country model to represent the core and periphery countries in the Eurozone. The model features fragile banks that can be subject to endogenous and costly runs. The two countries are financially integrated through an international interbank market. I introduce deposit insurance and compare different insurance regimes in steady state and along the business cycle. The model emphasizes that financial integration implies co-movement in asset prices and the transmission of shocks across the border. I find that when deposit insurance has lower coverage in the periphery than in the core, financial stability is undermined in both regions due to higher asset price volatility and a higher probability of deposit runs. Hence, either harmonizing or joining deposit insurance leads to substantial welfare benefits for both countries. In the third chapter, I develop a macroeconomic model with multiple equilibria and bank runs to analyze deposit insurance. A bank run is a sunspot equilibrium, and it is caused by a self-fulfilling panic of all depositors. The model features a unique no-run equilibrium when macroeconomic conditions are good, but an unexpected negative shock may open up the possibility of a run equilibrium. A bank run is a rare but costly event that drives the economy in a long and severe recession. I analyze the introduction and build-up of a deposit insurance fund and show that it reduces the cost and probability of bank runs. The dynamic simulation of the model reveals that deposit insurance diminishes macroeconomic and financial instability following a technological shock.

EPFL2018

Prices and portfolio choices in financial markets: Theory, econometrics, experiments

Many tests of asset-pricing models address only the pricing predictions, but these pricing predictions rest on portfolio choice predictions that seem obviously wrong. This paper suggests a new approach to asset pricing and portfolio choices based on unobserved heterogeneity. This approach yields the standard pricing conclusions of classical models but is consistent with very different portfolio choices. Novel econometric tests link the price and portfolio predictions and take into account the general equilibrium effects of sample-size bias. This paper works through the approach in detail for the case of the classical capital asset pricing model (CAPM), producing a model called CAPM+?. When these econometric tests are applied to data generated by large-scale laboratory asset markets that reveal both prices and portfolio choices, CAPM+?is not rejected. © The Econometric Society 2007.

2007

Ambiguity in Asset Markets: Theory and Experiment

This paper studies the impact of ambiguity and ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitudes toward ambiguity are heterogeneous across the population, just as attitudes toward risk are heterogeneous across the population, but that heterogeneity of attitudes toward ambiguity has different implications than heterogeneity of attitudes toward risk. In particular, when some state probabilities are not known, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This suggests a different cross section of portfolio choices, a wider range of state price/probability ratios, and different rankings of state price/probability ratios than would be predicted if state probabilities were known. Experiments confirm all of these suggestions. Our findings contradict the claim that investors who have cognitive biases do not affect prices because they are inframarginal: ambiguity-averse investors have an indirect effect on prices because they change the per capita amount of risk that is to be shared among the marginal investors. Our experimental data also suggest a positive correlation between risk aversion and ambiguity aversion that might explain the "value effect" in historical data. (JEL G11, G12, C92, D53)

2010

Financial Stability and the Macroeconomy

Corinne Dubois

EPFL2018