WORKING PAPERS
(Click on the title to download a paper)A component model for dynamic correlations
The idea of component models for volatility is extended to dynamic correlations. We propose a model of dynamic correlations with a short- and long-run component specification. We call it the class of models DCC-MIDAS as the key ingredients are a combination of the Engle (2002) DCC model, the Engle and Lee (1999) component GARCH model to replace the original DCC dynamics with a component specification and the Engle, Ghysels, and Sohn (2006) GARCH-MIDAS component specification that allows us to extract a long-run correlation component via mixed data sampling. We provide a comprehensive econometric analysis of the new class of models, including conditions for positive semi-definiteness, and provide extensive empirical evidence that supports the model specification. (with Rob Engle and Eric Ghysels)
Six Anomalies looking for a model. A consumption based explanation of International Finance Puzzles
When agents have a preference for the timing of the resolution of uncertainty the presence of a low frequency component in the dynamics of consumption growth can account for a number of anomalies including the Backus and Smith puzzle and the high correlation of stock markets given the almost absence of correlation in the fundamentals. The introduction of stochastic volatility allows also to resolve the forward rate premium anomaly, providing a unified framework to study international finance puzzles.
Risks for the long run and the real exchange rate
Abstract. Brandt, Cochrane, and Santa-Clara (2004) point out that the implicit stochastic discount factors computed using prices on the one hand and consumption growth on the other hand have very different implications for their cross country correlation. They leave this as an unresolved puzzle. We explain it by combining Epstein and Zin (1989) preferences with a model of predictable returns and by positing a very correlated long run component. We also assume that the intertemporal elasticity of substitution is larger than one. This setup brings the stochastic discount factors computed using prices and quantities close together, by keeping the volatility of the depreciation rate in the order of 14% and the cross country correlation of consumption growth around 30%. [This draft: Sep.11.2008] (with Max Croce)
Technical AppendixRisk Sharing for the Long-Run. The gains from financial integration
Abstract. Cole and Obstfeld (1991) pointed out that the welfare benefits of international portfolio diversification might be negligible. They obtain this result in the context of a model in which agents have time-additive constant relative risk aversion preferences. We revisit their conclusion by showing that a preference for the timing of the resolution of uncertainty combined with endowments containing a slowly moving trend can result in extremely high welfare gains. The model is also able to account for a large set of international finance stylized facts. Our setup allows us to bridge part of the gap between the current finance and international macroeconomic literatures. [This draft: Mar.11.2008] (with Max Croce)
On the existence of the exchange rate when agents have complete home bias and non-time separable preferences
Colacito and Croce (2006) study the dynamics of the growth rate of the real exchange rate, when the preferences of the representative consumers in the two countries are defined only over the domestic good and characterized by non-time separability a la Epstein and Zin (1989). This paper shows that an equilibrium of this economy exists in which exchange rates are well defined and it can be interpreted as the limiting case of an economy in which preferences are defined over both domestic and foreign goods. This note was originated as a response to a number of people that questioned the existence of an exchange rate in the absence of trade. [This draft Nov.27.2006.]