Essays on the Economics of Risk and Financial Markets

Abstract

Prices in financial markets are primarily driven by the interaction of risk and time. The returns to financial assets over long time horizons are primarily driven by fundamental news regarding their promised cash flows. In contrast, short-run price variation is associated with a large degree of predictable, transient investor trading behavior unrelated to fundamental prospects. The quantity of long-run risk directly affects economic well-being, and its magnitude has varied significantly over the past century. The theoretical model presented here shows some success in quantifying the impact of news about future risks on asset prices. In particular, some investing strategies that appear to offer anomalously large returns are associated with high exposures to future long-run risks. The historical returns to these portfolios are partly a result of investors’ distaste for assets whose worth declines when uncertainty increases. The financial sector is tasked with pricing these risks in a way that properly allocates investment resources. Over the past thirty years, this sector has grown much more rapidly than the economy as a whole. As a result, asset prices appear to be more informative. However, the new information relates to short-term uncertainty, not long-run risk. This type of high-frequency information is unlikely to affect real investment in a way that would benefit broader economic growth.