Final Report Summary - IMPC (INTERNATIONAL MONETARY POLICY COORDINATION AND DISTRESS CONTAGION)
This project proposes three distinct lines of research.
The first explores some asset pricing implications of the comovement in firms' idiosyncratic risks. In particular, it focuses on technological networks of firms, mapping the characteristics of the network connecting firm-specific risks to common variation in asset prices and the cross-section of expected returns. The latter view is formalized in the manuscript ‘Dynamic Networks and Asset Prices’, which features an equilibrium Lucas economy with multiple risky assets, where network connectivity is interpreted as the ability to transfer a distress state to other firms’ fundamentals in a directed and timely manner. The paper shows that ‘central’ firms, active at transferring but relative immune to transferred distress, have lower P/D ratios and higher expected returns. A measure of network centrality, ‘Dynamic Centrality’, is proposed and estimated on corporate earnings to confirm the theoretical relation between centrality and expected returns. The paper also argues that network centrality provides a micro-foundation to the predictive power of the size and book-to-market firm characteristics.
The second line of research focuses on international finance. It explores the effects on currency risk premia of news released by US monetary authorities (the Federal Open Market Committee, FOMC). Namely, the manuscript 'Policy Announcements in FX Markets', shows that a currency trading strategy that is short the US dollar and long a diversified portfolio of non US currencies earns large excess returns on days of scheduled FOMC meetings. Moreover, the difference between announcement and no-announcement returns becomes larger during periods of high uncertainty and bad economic conditions. To reconcile these findings with economic theory, the manuscript develops a model of an international long-run risk economy in which asset prices respond to revisions of monetary policy. Uncertainty pertaining the monetary policy revision commands a risk premium that is larger in weaker economic conditions. A calibrated version is consistent with the cross-sectional pattern of currency risk premia observed in the data.
The third line of research is concerned with uncertainty in fiscal policy, again from an asset pricing perspective. The manuscript 'Asset Pricing with Fiscal Uncertainty' proposes a dynamic general equilibrium model in which a public and a private sector coexist. The latter is populated by heterogeneous agents who learn about the impact of the public sector’s fiscal policy on firms' fundamentals. Agents disagree about the effectiveness of the government’s fiscal policy and their disagreement generates fiscal uncertainty risk that is priced in equilibrium. This theoretical analysis inspires a novel model-implied measure of fiscal disagreement, which is empirically estimated from a large cross-section of forecasts on future budget deficits. It turns out that firms whose returns are less sensitive to this proxy outperform highly sensitive firms by 6.58% annually. This negative implied market price of risk of fiscal uncertainty is highly statistically significant and cannot be explained by other standard risk factors. Finally, a calibrated version of the model matches well the empirical findings recovered in the data.
The first explores some asset pricing implications of the comovement in firms' idiosyncratic risks. In particular, it focuses on technological networks of firms, mapping the characteristics of the network connecting firm-specific risks to common variation in asset prices and the cross-section of expected returns. The latter view is formalized in the manuscript ‘Dynamic Networks and Asset Prices’, which features an equilibrium Lucas economy with multiple risky assets, where network connectivity is interpreted as the ability to transfer a distress state to other firms’ fundamentals in a directed and timely manner. The paper shows that ‘central’ firms, active at transferring but relative immune to transferred distress, have lower P/D ratios and higher expected returns. A measure of network centrality, ‘Dynamic Centrality’, is proposed and estimated on corporate earnings to confirm the theoretical relation between centrality and expected returns. The paper also argues that network centrality provides a micro-foundation to the predictive power of the size and book-to-market firm characteristics.
The second line of research focuses on international finance. It explores the effects on currency risk premia of news released by US monetary authorities (the Federal Open Market Committee, FOMC). Namely, the manuscript 'Policy Announcements in FX Markets', shows that a currency trading strategy that is short the US dollar and long a diversified portfolio of non US currencies earns large excess returns on days of scheduled FOMC meetings. Moreover, the difference between announcement and no-announcement returns becomes larger during periods of high uncertainty and bad economic conditions. To reconcile these findings with economic theory, the manuscript develops a model of an international long-run risk economy in which asset prices respond to revisions of monetary policy. Uncertainty pertaining the monetary policy revision commands a risk premium that is larger in weaker economic conditions. A calibrated version is consistent with the cross-sectional pattern of currency risk premia observed in the data.
The third line of research is concerned with uncertainty in fiscal policy, again from an asset pricing perspective. The manuscript 'Asset Pricing with Fiscal Uncertainty' proposes a dynamic general equilibrium model in which a public and a private sector coexist. The latter is populated by heterogeneous agents who learn about the impact of the public sector’s fiscal policy on firms' fundamentals. Agents disagree about the effectiveness of the government’s fiscal policy and their disagreement generates fiscal uncertainty risk that is priced in equilibrium. This theoretical analysis inspires a novel model-implied measure of fiscal disagreement, which is empirically estimated from a large cross-section of forecasts on future budget deficits. It turns out that firms whose returns are less sensitive to this proxy outperform highly sensitive firms by 6.58% annually. This negative implied market price of risk of fiscal uncertainty is highly statistically significant and cannot be explained by other standard risk factors. Finally, a calibrated version of the model matches well the empirical findings recovered in the data.