WORKING PAPERS
International Asset Pricing with risk-sensitive rare events.
We propose a general equilibrium model in which two international
representative consumers with recursive preferences trade two
consumption goods and a complete set of date and state contingent securities.
Consumption home bias and concern for the temporal distribution of risk generate
a rich dynamics for international prices and quantities, featuring a large and time-varying
volatility of exchange
rate movements and time-varying equity risk-premia. (with Max Croce)
Risk sensitive allocations with multiple goods. Existence, survivorship, and the curse of the linear approximation.
We characterize the equilibrium of a complete markets economy with multiple
agents displaying 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 show that a first order
Taylor expansion about the unconditional mean of the economy is not only highly inaccurate,
but it also allows for the possibility of one agent dying in the long-run. [Available December 2009] (with Max Croce)
The short- and long-run benefits of financial integration
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. [Prepared for the American Economic Review Papers and Proceedings] (with Max Croce)
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 Int'l 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
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%. (with Max Croce)
Risk Sharing for the Long-Run
We show that a model in which agents have a preference for the timing of the resolution of
uncertainty and in which endowments contain a slowly moving trend is 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. (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.]