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Asset pricing
In this section, the reports deal with articles on asset pricing: asset pricing models, stochastic discount factors, equity premium puzzle, consumption-based models, habit-persistence models, multi-factor models, pricing anomalies, asset return predictability, credit spreads, credit models etc...

The Virtues and Vices of Equilibrium

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The Virtues and Vices of Equilibrium and the Future of Financial Economics
John Geanakoplos and Doyne Farber


In this working paper from the Cowles Foundation at Yale University, economist John Geanakoplos and physicist Doyne Farber provide a very insightful discussion of the state of financial economics and its future using insights from other sciences such as physics and biology.

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The Cost of Active Investing

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Presidential Address: The Cost of Active Investing

In this paper, Kenneth R. French compares the fees, expenses, and trading costs, what society pays to invest in the U.S. stock market along with an estimate of what would be paid if everyone invested passively.

 

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The Dollar-Euro Exchange Rate and the Limits of Knowledge

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The Dollar-Euro Exchange Rate and the Limits of Knowledge

By Roman Frydman and Michael D. Goldberg

1 Introduction
In the very beginning of the new European currency, the Dollar seemed to be overvalued, and then the Euro started not only to catch up, but skyrocketed to a 30% overvaluation, according to PPP.
Given this extraordinary rally, it is legitimate to wonder what the future evolution will be. Unfortunately it is impossible to foresee the behaviour of the exchange rate using macroeconomic fundamentals as they are the very same that led to the current situation; some studies otherwise attribute the path of the currencies to market irrationality, making it impossible to be described with in a model; moreover, practitioners and journalists often use macroeconomic fundamental when they have to justify exchange rates movements.

2 Lost Fundamentals in Contemporary Economic Models
This section inquires the methodology of forecasting under the assumption of the limits of human knowledge, which are the very cause of the unpredictability of some events. They call this approach “Imperfect Knowledge Economics”, IKE.
Agents in the financial markets are able to see the dynamic relation that ties exchange rate to macroeconomic fundamentals, but due to limited knowledge, it is impossible to implement that intuition into an econometric model, in other words, to obtain forecasts.
For the very same reason, a model that includes only systematic information and that exclude any change in fundamentals, is completely useless because it is no more than a descriptive tool. When such a model is used for forecasting, the results are not better than naïve model ones, i.e. tossing a coin.

3 Understanding Markets in Capitalist Economies
There is not a unique strategy that agents set in financial market to forecast exchange rates and to face them. This statement implies that the final behaviour of the currency is lead by a number of rational and irrational factors, by both quantitative and qualitative measures.
Under the IKE paradigm, they build a model that can predict exchange rates behaviour exploiting the qualitative regularities that financial markets show.

4 and 5 The Near and Longer Term Outlook for the Dollar-Euro Exchange Rate
IKE model is an alternative to both rational expectation and behavioural models; it is based on the assumption that the agents do not share the same model, allowing for different forecasts. Decisions are based upon macroeconomic fundamentals and revisions of previous results and assumptions. Revisions are purely random, so they can not be foreseen. When a persisting trend in fundamentals is combined with a low inclination in revising forecasts, then deviations from PPP appear.
In terms of the current Dollar-Euro exchange rate issue, then, we shall see convergence toward PPP when there is a change in conservative revisions or in macro trends.

In the long term, the exchange rate reverts towards PPP. Even if significant deviation may occur sometimes, they are bounded: at certain level bulls in the market will be so concerned about a reversal, that it will occur. We can not say if the exchange rate will stay still at its PPP level or shoot in the opposite direction as happened to the Dollar-Euro ratio.

6 A New Policy Proposal for Limiting the Magnitude of Exchange Rate Swings

The authors’ proposal implies a sort of exchange rate targeting, where the central bank declares its objectives in terms of parity values every month, to stabilize markets and avoid large swings.

http://www.earthinstitute.columbia.edu/ccs/documents/IKE%20of%20Dollar-Euro%20Exchange%20Rate%20RF_MDG%2011_7_2007_CCS.pdf

 

More Than Words: Quantifying Language to Measure Firms’ Fundamentals

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More Than Words: Quantifying Language to Measure Firms’ Fundamentals  

Paul C. Tetlock, Maytal Saar-Tsechansky, and Sofus Macskassy establish how linguistic media content captures the aspects of firms’ fundamentals which investors quickly include in stock prices. In this paper, the authors measure the language used in financial news stories to predict firms’ accounting earnings and stock returns. In addition, they investigate whether negative words can be used to improve expectations of firms’ future cash flows.
I. Research on Qualitative Information
The authors create two columns including negative and positive word categories in the predetermined dictionary.  A story’s negativity is measured according to the relative frequency of negative words in each news story.
II. Stylized Facts about Firm-Specific News Stories
The authors analyze the fraction of negative words in DJNS and WSJ stories about S&P 500 firms from 1980 to 2004. There are many more firm-specific news stories in the days immediately surrounding a firm’s earnings announcement. For each firm-specific news story, the authors compute the number of days until the firm’s next earnings announcement and the number of days that have already passed since the firm’s previous earnings announcement. It is found that news stories play a significant important role in communicating and disseminating information about firms’ fundamentals.
III. Using Negative Words to Predict Earnings
The authors confirm that negative words in a firm’s news stories prior to the firm’s earnings announcement measure the otherwise hard-to-quantify unfavorable aspects of the firm’s business environment. These negative words consistently predict lower earnings.
IV. Using Negative Words to Predict Stock Returns
The authors investigate whether negative words predict firms’ future stock returns.
A. Predicting Returns in Story Event Time
The authors evaluate whether fractions of negative words in firm-specific news stories on day zero predict firms’ close-to-close stock returns on day one.
B. Predicting Returns in Calendar Time
The difference between the abnormal returns of firms with positive and negative DJNS news stories is shown.
V. Interpreting the Earnings and Return Predictability
The main stylized facts are 1) news stories about firms are concentrated around their earnings announcements; 2) negative words in firm-specific stories predict low firm earnings in the next quarter; and 3) negative words about firms predict low firm stock returns on the next trading day. The authors check whether negative words in stories containing the word stem “earn” predict earnings better than negative words in other stories. In addition, contemporaneous market reactions and subsequent market underreactions are larger for stories that mention the word stem “earn” than for other stories. 
VI. Conclusion
The authors conclude that negative words in financial press predict low firm earnings. Besides, stock market prices include the information rooted in negative words with a slight delay.

Tetlock, Paul C., Saar-Tsechansky, Maytal and Macskassy, Sofus, "More than Words: Quantifying Language to Measure Firms' Fundamentals" (May 2007). 9th Annual Texas Finance Festival Available at SSRN: http://ssrn.com/abstract=923911

 

Portfolio Choice over the Life-Cycle when the Stock and Labor Markets (...)

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Portfolio Choice over the Life-Cycle when the Stock and Labor Markets are Cointegrated  

In this paper, Luca Benzoni, Pierre Collin-Dufresne, and Robert S. Goldstein examine portfolio choice over the life cycle when labor income and dividends are cointegrated.
I. A Model with Cointegrated Dividends and Labor Income
The authors present the life-cycle portfolio choice model.
A. Empirical Motivation for the Labor Income Model
The authors prove that labor income and dividend are cointregrated.
B. The Agent
The current financial wealth of the agent, placed in risky and risk-free asset, is analyzed.
C. Present Value of Labor Income
The authors estimate the present value of the agent’s labor income.
II. Accounting for Predictability in Returns
The authors investigate whether their results regarding optimal stock holdings are robust when long-run return predictability is taken into account.
A. Empirical Motivation for the Model with Return Predictability
The authors use variables such as dividend yield to capture asset return predictability.
B. Modeling Predictability
The authors expand the model to justify the predictability in stock returns.
III. Model Calibration
1. Labor Income Dynamics
The details of model calibration regarding labor income are presented.
2. Deterministic Life-Cycle Labor Income Profile
The authors find the deterministic labor income profile of twenty year old college educated agent.
3. Transitory Income Shocks
The transient income shocks are estimated.
4. Risky Asset and Riskfree Bond
The life-cycle portfolio holdings for risky asset and riskfree bond are calculated.
5. Preferences
The authors generate a wealth accumulation profile over the life cycle for college educated households.
6. Initial Conditions
The authors study the case of a twenty-year old agent.
IV. Simulation Results
The authors produce their findings.
A. Baseline Case
The cointegration of dividend and labor income leads the young agent’s human capital to showcase stock like features. In addition, most of the young agent's wealth is tied up in future labor income. Conversely, for older agents nearing retirement, cointegration does not have enough time to act and so, human capital takes on bond-like features. Consequently, these effects create hump-shaped i.e. increasing life-cycle portfolio holdings at the age of 50 to 60.
B. Human Capital
The authors compute the human capital of a twenty-year old agent. It is also observed that the human capital of an agent nearing retirement becomes small.
C. Robustness Results
The authors study the robustness of their results due to the changes in parameter estimates. 
C.1.   Speed of Mean Reversion and the Equity Premium
 The authors check their results with respect to equity premium.
C.2.   Contemporaneous Correlation of Stock Returns and Aggregate Labor Income Shocks
 The authors illustrate the contemporaneous correlation of stock returns and aggregate labor income.
C.3.   Persistent Idiosyncratic Labor Income Shocks
The authors note an increase in the idiosyncratic labor income variance has two opposite effects on the investor's desired portfolio holdings i.e. background risk and providing diversification motive.
C.4.   Transitory Idiosyncratic Labor Income Shocks
The transient idiosyncratic labor income shocks have small implications for the optimal portfolio choice problem solution.
C.5.   Relative Risk Aversion
The authors show the relative risk aversion of young agent and older agent nearing retirement.
C.6.   Short-Sale Constraints
It has now become easier for young agents to take short positions in the market portfolio.
C.7.   Predictability
 The young agents continue to invest in the stock market even in the presence of stock return predictability.

V. Conclusion
The authors conclude that agent's labor income is cointegrated with the dividend on the market portfolio. It is also found that young investors take substantial short positions in risky portfolio.


Benzoni, Luca, Collin-Dufresne, Pierre and Goldstein, Robert S., "Portfolio Choice Over the Life-Cycle when the Stock and Labor Markets are Cointegrated" (November 2007). FRB of Chicago Working Paper No. 2007-11 Available at SSRN: http://ssrn.com/abstract=875984

 
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