Working Papers
- Long Rates, Life Insurers, and Credit Spreads
[ | | PDF File ]- Ben Bernanke Prize in Financial and Monetary Economics, Princeton University
- Brattle Group Ph.D. Candidate Award For Outstanding Research, WFA
- Kuldeep Shastri Outstanding Doctoral Student Paper, Eastern FA
Abstract: Post-2008, corporate bond credit spreads decline when long-term interest rates increase, particularly for lower-rated bonds. This is true unconditionally but also conditional on monetary policy announcements. In the cross-section, this negative co-movement between long rates and credit spreads is more pronounced for bonds predominantly held by life insurers. I develop a quantitative framework that rationalizes these findings. In the model, life insurers with long-duration liabilities face duration mismatch and therefore realize equity gains when long rates increase. As a result, their effective risk aversion declines, driving down equilibrium credit spreads. The model explains the majority of the empirical credit spread responses to long rates. The model also shows that life insurers' duration mismatch can dampen or even reverse the transmission of unconventional monetary policy to bond yields and issuance.
Selected Presentations (incl. scheduled): Duke Fuqua, CU Boulder Leeds, MSU Broad, WashU Olin, Maryland Smith, Yale SOM, MIT Sloan, LSE, UIUC Gies, OSU Fisher, Imperial College Business School, Georgetown McDonough, Minnesota Carlson, CUHK, HKU, CKGSB, WFA, Young Scholars Finance Consortium at TAMU, EEA-ESEM, Eastern FA
- Deposit Market Power and Bank Risk-Taking
(with Jihong Song)
[ | PDF File ]
Abstract: We document a novel fact about the cross-section of banks’ risk-taking behavior — banks with high deposit market power take on significantly less credit risk. In particular, the loan portfolios of high-market-power banks are much safer than those of low-market-power banks. This persistent relationship is not driven by banks' size, funding structure, loan market power, or geography. Consequently, high-market-power banks earn higher profits, are less exposed to business cycle fluctuations, and sustain smaller losses in recessions. We propose a model where deposit market power increases banks’ franchise value and induces them to take on less risk to avoid defaults.
- Flight-to-Safety in a New Keynesian Model
(with Sebastian Merkel)
[ | PDF File ]
Abstract: Recent economic recessions feature dramatic rises in uncertainty. Empirical studies have found large-scale portfolio rebalancing towards nominally safe assets in times of high uncertainty. This paper builds a New Keynesian model with idiosyncratic risk and incomplete markets to study the transmission of uncertainty shocks through investors' portfolio decisions and how monetary-fiscal policy can stabilize fluctuations in demand for safe assets. In response to a sudden increase in uncertainty, investors reallocate their resources from productive assets to safe assets for precautionary motives. When prices are sticky, the heightened demand for safe assets leads to overshooting in capital price, which gives rise to aggregate demand recessions. Conventional monetary policy that operates through interest rate changes alone has limited power in influencing household portfolios. Instead, fiscal policy plays a crucial role in price stabilization and optimal policy.
- Cognitive Imprecision and Stake-Dependent Risk Attitudes
(with Mel Khaw and Michael Woodford)
[ | PDF File | Old Version: NBER, CESifo ]
Abstract: In an experiment that elicits subjects’ willingness to pay (WTP) for the outcome of a lottery, we document a systematic effect of stake sizes on the magnitude and sign of the relative risk premium, and find that there is a log-linear relationship between the monetary payoff of the lottery and WTP, conditional on the probability of the payoff and its sign. We account quantitatively for this relationship, and the way in which it varies with both the probability and sign of the lottery payoff, in a model in which all departures from risk-neutral bidding are attributed to an optimal adaptation of bidding behavior to the presence of cognitive noise. Moreover, the cognitive noise required by our hypothesis is consistent with patterns of bias and variability in judgments about numerical magnitudes and probabilities that have been observed in other contexts. We thus provide foundations for the kind of nonlinear distortions in lottery valuation posited by prospect theory, that we believe can provide an interpretation for the observed instability across contexts of estimated prospect-theoretic parameters.
Publications
- Cognitive Imprecision and Small-Stakes Risk Aversion
(with Mel Khaw and Michael Woodford)
The Review of Economic Studies, July 2021
[ | PDF File | Published Version | Replication | Subsumed NBER WP ]
Abstract: Observed choices between risky lotteries are difficult to reconcile with expected utility maximization, both because subjects appear to be too risk averse with regard to small gambles for this to be explained by diminishing marginal utility of wealth, as stressed by Rabin (2000), and because subjects’ responses involve a random element. We propose a unified explanation for both anomalies, similar to the explanation given for related phenomena in the case of perceptual judgments: they result from judgments based on imprecise (and noisy) mental representations of the decision situation. In this model, risk aversion results from a sort of perceptual bias — but one that represents an optimal decision rule, given the limitations of the mental representation of the situation. We propose a quantitative model of the noisy mental representation of simple lotteries, based on other evidence regarding numerical cognition, and test its ability to explain the choice frequencies that we observe in a laboratory experiment.
- Temporal Discounting and Search Habits: Evidence for a Task-Dependent Relationship
(with Mel Khaw and Michael Woodford)
Frontiers in Psychology, November 2018
[ | PDF File | Published Version ]
Abstract: Recent experiments suggest that search direction causally affects the discounted valuation of delayed payoffs. Comparisons between options can increase individuals’ patience toward future payoff options, while searching within options instead promotes impatient choices. We further test the robustness and specificity of this relationship using a novel choice task. Here individuals choose between pairs of delayed payoffs instead of single delayed outcomes. We observe a relationship between search styles and temporal discounting that are the opposite of those previously reported. Integrators — those who tend to compare attributes within alternatives — discount and choose more slowly than comparators — those who are more likely to compare between alternatives. This finding supports and augments the view that individuals’ search strategy is predictive of subsequent discount rates. In particular, the direction of this relationship is further modifiable based on the spatial layout and varying information within an individual’s decision-making environment.