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IFAP Report Summary

Project ID: 263312
Funded under: FP7-IDEAS-ERC
Country: United Kingdom

Final Report Summary - IFAP (Institutional Frictions in International Finance and Asset Pricing)

My first body of work explores theoretically the effects of institutional investors on asset prices. In a departure from leading representative-agent based theories in asset pricing, I introduce institutional investors as a distinct class of investors who participate in trading, and hence pricing, of financial assets. In "Asset Prices and Institutional Investors" (American Economic Review, 2013, with S. Basak), I postulate that institutional investors differ from other investors because they are benchmarked to a certain index. This results in markedly different behaviour of index assets relative to nonindex. In particular, index assets have higher prices, higher return volatilities and correlations than nonindex assets. The paper also finds that institutional investors have strong incentives to take on leverage or excessive risk, especially in good economic times.

Turning to the feedback from financial markets to the real economy,"A Model of Financialization of Commodities" (Journal of Finance, 2016, with S. Basak) seeks to examine an intriguing hypothesis that the emergence of commodities as an asset class in institutional investors' portfolios has been responsible for remarkable changes in commodity futures volatilities and correlations as well as in commodity spot prices and inventories. The paper shows that institutional investors indeed push up commodity prices and inventories and make commodities more correlated with other asset classes held in institutional investors' portfolios---such as, for example, equities. Moreover, sudden movements in prices of index commodities affect prices of other, possibly unrelated, commodities as long as those commodities are part of institutional investors' portfolios. The more institutional money is invested in commodities, the stronger these effects become.

My final body of work explores the interconnections between international financial markets and the real economy. An important issue debated in the current open economy macroeconomics literature is whether the unprecedented current account deficits in the US and other developed countries are sustainable. Recent empirical literature has documented a dramatic increase in cross-country equity holdings in the past two decades, and specifically that the returns on assets of many developed countries, most notably the US, were higher than the returns on the liabilities. This means that capital gains on the net foreign asset positions could have been financing current account deficits in those countries and therefore the deficits are more sustainable than previously thought. While the debate about sustainability is far from over, one conclusion is undisputed: we need new theories that can formalise this debate by linking external accounts to cross-country equity holdings. In "Equilibrium Portfolios and External Adjustment Under Incomplete Markets" (working paper, with R. Rigobon), we build a model of an international economy with cross-country equity holdings and redefine the current account so as to include the effects of asset cross-holdings and show that its behaviour is very different from that of its traditionally-defined counterpart. We also derive a set of properties that a sustainable economy should exhibit. An invited survey "International Macro-Finance" (with R. Rigobon, Handbook of Safeguarding Global Financial Stability, Elsevier (2013)) synthesizes much of my work undertaken in collaboration with R. Rigobon, surveys the related literature in international macro-finance and outlines avenues for future research in the field.

My work, described above, has been presented at many universities, including HEC Paris, INSEAD, London School of Economics, Northwestern University (Kellogg), Stockholm School of Economics, University of Chicago, University of North Carolina, University of Southern California, University of Toulouse, and at most major academic conferences, including meeting of American Economic Association, American Finance Association, European Finance Association, CEPR and NBER. It has appeared in top economics and finance journals and attracted over 300 citations in Google Scholar.

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United Kingdom
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