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Market Beliefs and Optimal Policy in the Presence of Disasters

Periodic Reporting for period 4 - Disasters (Market Beliefs and Optimal Policy in the Presence of Disasters)

Reporting period: 2019-11-01 to 2020-07-31

The proposal comprises two themes that are linked by a concern for the importance of extreme events, in financial markets and more generally. Work on the two themes is ongoing throughout the time span of the project.

Aside from its intrinsic academic interest, the first theme, Option-implied measures of market beliefs, will have important applications for the financial industry and for policymakers and regulators. The goal is to develop ways of using observable asset-price data to infer the beliefs of market participants about various quantities that are central to financial economics, such as (i) the equity premium; (ii) the forward-looking autocorrelation of the market (i.e. time-series momentum); (iii) the risk premia associated with individual stocks; (iv) measures of correlation between stocks; and (v) measures of asymmetric risk, such as the forward-looking probability of a significant downward jump in the stock market over some prescribed time period.

Improving understanding of these issues will help policymakers as they react to market turbulence, investors as they interpret market gyrations and plan savings (for retirement or otherwise); and more generally will help society allocate capital more efficiently.

The second theme, Policy responses to catastrophes: The economics of Scylla and Charybdis, proposes a framework for thinking about government policy regarding the various potential catastrophes that confront society. (An incomplete list would include climate change; public health catastrophes such as mega-viruses; nuclear or bio-terrorism; and meteorite strikes. The legal scholar Richard Posner (2004) provides more examples of potential catastrophes and argues that society fails to take such risks sufficiently seriously.) This work is joint with Robert S. Pindyck of MIT, who is one of the world’s leading experts on the economics of climate change; our collaboration started at the TIGER Forum on environmental economics in Toulouse, organized by Christian Gollier. The goal is to provide a framework to help policymakers, faced with multiple different types of potential catastrophe, to decide how society’s limited resources should best be used to alleviate the risks of severe catastrophes.
"Several papers have been published in top journals. These answer the central questions addressed by the project. The papers are as follows.

1) ""Averting Catastrophes: The Strange Economics of Scylla and Charybdis"" (joint with Robert Pindyck) was published in the American Economic Review in 2015.

2) ""What is the Expected Return on the Market?"" was published in the Quarterly Journal of Economics in 2017.

3) ""Notes on the Yield Curve"" (joint with Steve Ross) was published in the Journal of Financial Economics in 2019.

4) ""The Quanto Theory of Exchange Rates"" (joint with Lukas Kremens) was published in the American Economic Review in 2019.

5) ""What is the Expected Return on a Stock?"" (joint with Christian Wagner) was published in the Journal of Finance in 2019.

6) ""Welfare Costs of Catastrophes: Lost Consumption and Lost Lives"" (joint with Robert Pindyck) is forthcoming in the Economic Journal.

7) ""On the Autocorrelation of the Stock Market"" is forthcoming in the Journal of Financial Econometrics.

A further paper is currently being revised for resubmission to a top journal:

8) ""Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment"" (joint with Can Gao)

Some of these (notably 2, 4, 5, and 8) have attracted considerable interest from private sector organisations and from policy institutions including the ECB, Banca d'Italia, Sveriges Riksbank, Bank of England, and the Federal Reserve Banks of New York and of Atlanta.

Paper 8 has recently been taken up by researchers at the Bank of England who now disseminate within the Bank an indicator of sentiment introduced in the paper. This was recently written up in a post on the ""Bank Underground"" official blog."
Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment