Abstract: This paper investigates how interest rate fluctuations shape life insurance markets, focusing on the liability adjustments insurers employ to manage interest rate risk. After the 2008 Financial Crisis, insurers exposed to high interest rate risk -- such as those offered variable annuities with minimum return guarantees pre-2008 -- shifted their product portfolios toward short-duration policies to hedge against rising duration gaps. Using a combination of theoretical and empirical analysis, we show that this liability rebalancing led to sizable contractions in both the supply of long-duration life insurance products and the aggregate life insurance market. Our findings reveal that interest rate risk can significantly influence financial intermediaries' liability choices, which in turn shape the composition and availability of financial products.

Selected Presentations (* = by coauthor): CICF, AFA*

Abstract: This paper examines how the duration mismatch of life insurance companies, the largest institutional investors in the US corporate bond market, affects credit spread dynamics. Post-GFC, US life insurers face large and negative duration gaps. When long-term interest rates increase, life insurers realize equity gains, which boost their risk-bearing capacity and compress credit spreads. Empirically, post-2008, corporate bond credit spreads decline when long rates rise, which holds both unconditionally and around monetary policy announcements. In the cross-section, I utilize a regression discontinuity design to confirm that this negative co-movement is more pronounced for bonds held more by life insurers.

Selected Presentations: Bocconi, CKGSB, CUHK, CU Boulder Leeds, Duke Fuqua, Georgetown McDonough, HKU, Imperial College Business School, LSE, Maryland Smith, Minnesota Carlson, MIT Sloan, MSU Broad, OSU Fisher, UIUC Gies, WashU Olin, Yale SOM; AFA, WFA, Eastern FA, Young Scholars Finance Consortium (TAMU), EEA-ESEM, FSRC Macro-Finance Conference (Bank of Canada), San Francisco Fed Fixed Income Conference, CEBRA Annual Meeting

Abstract: We incorporate flight to safety in a tractable New Keynesian model with incomplete markets and nominal safe assets. A rise in uncertainty induces a flight to safety, where investors shift portfolios from risky productive capital to nominal government bonds. Under price stickiness, the real value of nominal safe assets cannot adjust flexibly, causing capital price overshooting and aggregate demand recessions. Conventional monetary policy through the nominal rate has limited power in mitigating these recessions, as it fails to directly affect portfolio reallocation between safe and risky assets. Instead, optimal monetary policy allows temporary deviations from price stability, leveraging inflation dynamics to indirectly manage safe asset supply.

Selected Presentations (* = by coauthor): Princeton University, Mannheim University*, University of Sydney*, Monash University*, National University of Singapore*, University of Porto*; CESifo Area Conference on Macro, Money, and International Finance*, MMF Society Annual Conference, BSE Summer Forum*, NBER Summer Institute*

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. In addition to providing foundations for the kind of nonlinear distortions in lottery valuation posited by prospect theory, our model explains why the degree of stake-dependence should be greater for certainty-equivalents elicited by requiring subjects to assign a dollar value to lotteries than for those implied by binary choices.

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.

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.

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.