Essays in Financial Economics

Abstract

The first essay studies consumption-based asset pricing models in which consumers make mistakes. I build a model in which a portfolio manager selects portfolio weights on behalf of a potentially non-optimizing consumer. In the case of power utility, risk premia depend on exposure to long-horizon consumption and expected return shocks, not single-period consumption as in the standard model. My results apply to a wide range of environments and generalize beyond power utility. In the general case, long-horizon risks matter when consumers do not react to shocks optimally. I provide empirical evidence that expected return shocks are negatively priced in the cross section of stock returns, as the model predicts, and can account for 1.3 percentage points of the equity premium.

The second essay, coauthored with Weiling Liu, proposes a novel measure of intermediary risk constraints called the interdealer broker (IDB) index, which captures the portion of total trade volume conducted between dealers using an IDB. Theoretically, when aggregate risk constraints tighten, dealers will use IDBs more in order to redistribute idiosyncratic risk. Empirically, we test our measure in the U.S. Treasury market, where we find that the IDB index has a 0.72 correlation with interest rate risk, as proxied by Value-at-Risk. Furthermore, a one standard deviation increase in the IDB index forecasts a 1.8 percentage point higher annual excess return on a five-year bond. This return predictability holds across different fixed income classes, over varying maturities, as well as out-of-sample.

The third essay studies the optimal risk taking of a endowment manager who invests on behalf of an endowment with limited flexibility to adjust its spending. I model this limited flexibility in reduced-form by assuming the endowment follows a spending policy which only gradually adjusts to changes in wealth, in line with Yale and many other universities. In my benchmark case, I find that endowments should optimally reduce their risky asset holdings by 4 to 7 percentage points if following a rule similar to Yale's. I additionally develop a new methodology to approximately solve portfolio choice problems when spending policies are not necessarily optimal.