an image Working papers: where great ideas come to life...

Recursive Allocations and Wealth Distribution with Multiple Goods: Existence, Survivorship, and Dynamics

Coauthor: Max Croce (UNC). Draft date: May 2014.

We characterize the equilibrium of a complete markets economy with multiple agents featuring a preference for the timing of the resolution of uncertainty. Utilities are defined over an aggregate of two goods. We provide conditions under which the solution of the planner's problem exists and it features a non-degenerate invariant distribution of Pareto weights. We also show that perturbation methods replicate the salient features of our recursive risk-sharing scheme, provided that higher order terms are included.

The Term Structures of Co-Entropy in International Financial Markets

Coauthor: Fousseni Chabi-Yo (Ohio State). Draft date: October 2013.

We propose a new entropy-based correlation measure (co-entropy) to evaluate the performance of international asset pricing models. Co-entropy summarizes in a single number the extent of co-dependence between two variables beyond normality. We document that the co-entropy of international stochastic discount factors (SDFs) can be decomposed into a series of entropy-based correlations of permanent and transitory components of the SDFs. We derive bounds and restrictions on co-entropies of these components, which we then use to analyze the composition of co-dependence of international SDFs. A large cross-section of countries is employed to provide empirical evidence on the entropy-based correlations at various horizons. We find that the co-entropy of the transitory components is always sizably smaller than the co-entropy of the permanent components. Furthermore, the entropy-based correlation of transitory components of SDFs increases with the investment horizon featuring an upward sloping term structure of co-entropies. We confront several state of the art international finance models with these empirical regularities, and find that existing models cannot account for the composition of co-dependence at all horizons.

Robust Exchange Rates and the International Entropy Frontier

Coauthor: Max Croce (UNC Chapel Hill). Draft date: January 2014.

We characterize an international trading scheme based on entropy risk-sharing. In our frictionless general equilibrium model, two international consumers with preferences for robustness trade both two consumption goods and a complete set of date- and state-contingent securities. Consumption home bias and concern for the temporal distribution of entropy generate rich endogenous dynamics for high moments of both international prices and quantities.

BKK the EZ way: An International Production Economy with Recursive Preferences

Coauthors: Max Croce (UNC), Steven Ho (Tsingua), Philip Howard (UNC Chapel Hill). Draft date: April 2013.

We characterize an international production economy in which: (1) agents have Epstein and Zin (1989) preferences, (2) international productivity frontiers are exposed to both short- and long-run shocks, and (3) consumption features a larger degree of home bias relative to investment. Under our recursive risk-sharing scheme, relative good long-run news to domestic productivity create a net outflow of domestic investments. This response accounts for the Backus, Kehoe and Kydland (1994) anomaly, concerning the lower degree of correlation of international consumption relative to output. We document that our model is strongly consistent with novel empirical evidence on both international quantities and prices.

Skewness in Expected Macro Fundamentals and the Predictability of Equity Returns: Evidence and Theory

Coauthors: Eric Ghysels (UNC), Jinghan Meng (UNC), Wasin Siwasarit (UNC). Draft date: April 2013.

We show that introducing time-varying skewness in the distribution of expected growth prospects in an otherwise standard endowment economy can up to double the model implied equity Sharpe ratios, and produce a substantial amount of fluctuation in equity risk premia. Looking at the Livingston Survey, we document that the first and third cross-sectional moments of the distribution of GDP growth rates made by professional forecasters can predict equity excess returns, a finding which is consistent with our consumption based asset pricing model.

Someone Likes it Skewed: an Experimental Analysis of Skewness and Risk Aversion

Coauthors: Anna Bassi (UNC) and Paolo Fulghieri (UNC). Draft: coming soon!

We modify the multiple price listing design of Holt and Laury (2002) to study the trade-off between expected payoff and payoff’s skewness. We find that our subjects are equally split between those that are and those that are not averse to negative skewness, despite the fact that they all display risk aversion in the standard Holt and Laury (2002) treatment. We estimate the parameters of a power-expo utility function only on the subset of subjects, whose behavior across treatments is consistent with this functional form and find that relative risk aversion can be twice as large as what is typically found in these experiments.

Six Anomalies looking for a model. A consumption based explanation of International Finance Puzzles

Draft date: January 2009.

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.

On the existence of the exchange rate when agents have complete home bias and non-time separable preferences

Draft date: November 2006.

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.