Abstract: Post-2008, corporate bond credit spreads decline when long-term interest rates increase. The pattern holds both unconditionally and around monetary policy announcements. In the cross-section, this negative co-movement is more pronounced for bonds held by life insurers. To rationalize these findings, I propose a model where life insurers with long-duration liabilities face duration mismatch and realize equity gains when long rates increase. The equity gains boost insurers’ risk-bearing capacity and drive down equilibrium credit spreads. The model quantitatively explains the empirical finding and shows that insurers’ duration mismatch can dampen or reverse unconventional monetary policy transmission to bond yields and issuance.

Selected Presentations (incl. scheduled): 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)

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: 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.

Selected Presentations (incl. scheduled, * = by coauthor): Princeton, Mannheim University*, University of Sydney*; CESifo Area Conference on Macro, Money, and International Finance*, Money, Macro and Finance Society Annual Conference

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.