Working Papers

-- Under review --

Bundesbank Discussion Paper No. 12/2022

Abstract: Using survey data from German households, we find that individuals with lower climate concern tend to have higher inflation expectations up to five years ahead. This correlation is most pronounced among individuals with extremely high inflation expectations. Evaluating candidate explanations, we find that part of the link between climate concern and inflation expectations can be associated with individuals' perceived exposures to climate-related risks and with their distrust in the central bank. Overall, our results suggest that climate change perceptions matter for inflation expectations.

  • Goodarzi, M., Meinerding, C. (2022): Regime-Based Asset Allocation with Parameter Learning

-- Draft available soon --

Abstract: This article studies long-horizon dynamic asset allocation strategies with parameter learning. The parameter estimates for the regime-switching dynamics vary as more and more datapoints are observed and the sample size increases. In such a setting, where the globally optimal portfolio strategy cannot be determined numerically, the portfolio performance can be improved substantially if the dynamics of economic regimes are estimated from fundamental macroeconomic data instead of financial return data. Especially after highly uncertain times like the burst of the dotcom bubble or the 2008 financial crisis, the estimation based on financial market data identifies extreme regimes, leading to very extreme hedging demands against regime changes.

-- Preliminary draft (new version coming soon) --

Presented at: ISEFI 2022 (Paris), Euroframe Conference 2021 (online), University of Zurich, Goethe University Frankfurt, ESCB, Deutsche Bundesbank

Abstract: We propose and implement a method to identify shocks to transition risk. We identify transition risk shocks as instances where a strong differential valuation of green versus brown firms coincides with significant information on climate change. For that purpose, we combine information from long-short equity portfolios sorted on firms' carbon footprints with information from textual analysis of newspaper archives. We find that shocks increasing transition risk (negative abnormal returns of brown firms) induce a decline in aggregate and sectoral industrial production. Moreover, they significantly affect financial stability, as measured by the excess bond premium or credit conditions more generally. Finally, we document a pronounced asymmetry in the economy's response to shocks increasing or decreasing transition risk.

-- Under revision --

Bundesbank Discussion Paper No. 62/2020

The paper also includes an online appendix. The Matlab code for the paper is available on Julian's webpage. A previous version of the paper was entitled "Elephants and the Cross-Section of Expected Returns".

Presented at: Midwest Finance Association 2020, Econometric Society European Winter Meeting 2019 (Rotterdam), DGF 2019 (Essen), SGF 2018 (Zurich), Frontiers of Factor Investing 2018 (Lancaster), Goethe University Frankfurt, Deutsche Bundesbank

Abstract: The estimation of misspecified linear factor models for the cross-section of expected returns with GMM can result in a spuriously high explanatory power when the estimated factor means are allowed to deviate substantially from the sample averages. In fact, by shifting the weights on the moment conditions, any level of cross-sectional fit can be attained. The mathematically correct global minimum of the GMM objective function can be obtained at a parameter vector that is far away from the true parameters of the data-generating process. This is not a property of small samples, but holds in population. It is a feature of the GMM estimation design and applies to strong as well as weak factors, and to all types of test assets.

-- Under revision --

SAFE Working Paper No. 129, Bank of Lithuania Working Paper No. 36/2016

Presented at: 11th Dynare Conference (Brussels), SGF 2016 (Zurich), 5th Annual Lithuanian Conference on Economic Research (Vilnius), 2016 World Finance Conference (New York), DGF 2016 (Bonn), University of Venice, 9th Biennial Conference of the Czech Economic Society (Prague), University of Bologna, Portsmouth Business School, University College of Dublin, 24th International Conference Computing in Economics and Finance (Milan)

Abstract: We document, both theoretically and empirically, that long-run investment productivity shocks help explain the joint behavior of macroeconomic quantities and asset prices. A two-sector general equilibrium model with long-run investment shocks and wage rigidities produces both positive co-movement among key macroeconomic variables and a sizable spread in expected returns and return volatilities between the investment and consumption sector. Moreover, long-run investment shocks command a positive risk premium. We filter long-run components from US sectoral TFP time series and find empirical evidence in favor of the key model mechanisms in both macroeconomic and asset pricing data.

-- Under revision --

SAFE Working Paper No. 34

Presented at: SGF 2014 (Zurich), DGF 2014 (Karlsruhe), DGVFM 2014 (Berlin), Wharton School, Goethe University Frankfurt

Abstract: We analyze the equilibrium in a two-tree (sector) economy with two regimes. The output of each tree is driven by a jump-diffusion process, and a downward jump in one sector of the economy can (but need not) trigger a shift to a regime where the likelihood of future jumps is generally higher. Furthermore, the true regime is unobservable, so that the representative Epstein-Zin investor has to extract the probability of being in a certain regime from the data. These two channels help us to match the stylized facts of countercyclical and excessive return volatilities and correlations between sectors. Moreover, the model reproduces the predictability of stock returns in the data without generating consumption growth predictability. The uncertainty about the state also reduces the slope of the term structure of equity. We document that heterogeneity between the two sectors with respect to shock propagation risk can lead to highly persistent aggregate price-dividend ratios. Finally, the possibility of jumps in one sector triggering higher overall jump probabilities boosts jump risk premia while uncertainty about the regime is the reason for sizeable diffusive risk premia.

These working papers represent the authors' personal opinions and do not necessarily reflect the views of the Deutsche Bundesbank or the Eurosystem.

All working papers can be downloaded from SSRN.

Articles in Refereed Journals

Bundesbank Discussion Paper No. 16/2019

Presented at: WFA 2018 (Coronado), SGF 2018 (Zurich), German Economists Abroad 2017 (Frankfurt), Paris December Finance Meeting 2017, DGF 2017 (Ulm), ESSFM 2017 (Gerzensee), MFA 2017 (Chicago), AFFI 2017 (Valence), 2017 Colloquium on Financial Markets (Cologne), Goethe University, Deutsche Bundesbank, Wharton, BI Oslo, IWH Halle, Swiss National Bank

Abstract: In a parsimonious regime switching model, expected consumption growth varies over time. Adding inflation as a conditioning variable, we uncover two states in which expected consumption growth is low, one with high and one with negative expected inflation. Embedded in a general equilibrium asset pricing model with learning, these dynamics replicate the observed time variation in stock return volatilities and stock-bond return correlations. They also provide an alternative derivation for a measure of time-varying disaster risk suggested by Wachter (2013), implying that both the disaster and the long-run risk paradigm can be extended towards explaining movements in the stock-bond correlation.

Bundesbank Discussion Paper No. 33/2020

Presented at: AFA 2020 Poster Session (San Diego), Bundesbank Spring Conference 2019, Conference on Systemic Risk and Financial Stability (University Freiburg), Workshop on Monetary and Financial Macroeconomics 2019 (Hamburg)

Abstract: We operationalize the definition of systemic risk provided by the IMF, BIS, and FSB and derive a two-stage hierarchical hypothesis test to identify indicators of systemic risk. Applying the framework to a set of candidate variables for 45 countries, we detect two credit-based financial cycle variables that, by and large, pass our test. However, for many other variables, including the Basel III credit-to-GDP gap, we find that elevated systemic risk is signaled by high values in some countries and by low values in others. More generally, our results suggest that, ex ante, systemic risk can be clearly identified only once the turning points of indicators have been observed.

SAFE Working Paper No. 74, Bundesbank Discussion Paper No. 37/2018

Abstract: Directed links in cash flow networks affect the cross-section of risk premia through three channels. In a tractable consumption-based equilibrium asset pricing model, we obtain closed-form solutions that disentangle these channels for arbitrary directed networks. First, shocks that can propagate through the economy command a higher market price of risk. Second, shock-receiving assets earn an extra premium since their valuation ratios drop upon shocks in connected assets. Third, a hedge effect pushes risk premia down: when a shock propagates through the economy, an asset that is unconnected becomes relatively more attractive and its valuation ratio increases.

Abstract: It is a major challenge for asset pricing models to generate a high equity premium and a low risk-free rate while imposing realistic consumption dynamics. To address this issue, our paper proposes a novel pricing channel: We allow for consumption drops that can spark an economic crisis. This new feature generates a large equity premium even if possible consumption drops are of moderate size. In turn, our model also matches the consumption data of 42 countries along several dimensions. In particular, our approach generates a realistic number of crises that have realistic durations and involve clustering of moderate consumption drops.

Abstract: This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.

Abstract: We study the impact of financial contagion on the dynamic asset allocation problem of a CRRA investor facing an incomplete market with two risky assets. We apply a Markov chain regime-switching framework with state-dependent jump intensities, diffusion volatilities and diffusion correlations. The key model feature that a switch to the bad contagion regime is triggered by a loss in one of the risky assets allows for the implementation of a hedging demand against contagion risk. Moreover, a state-dependent diffusion correlation combined with heterogeneity in jump intensities and volatilities can, e.g., generate a flight to quality effect upon a systemic jump.

Abstract: This paper provides a detailed overview of the current research linking systemic risk, financial crises and contagion effects among assets on the one hand with asset allocation and asset pricing theory on the other hand. Based on the ample literature about definitions, measurement and properties of systemic risk, we derive some elementary ingredients for models of financial contagion and assess the current state of knowledge about asset allocation and asset pricing with explicit focus on systemic risk. The paper closes with a brief outlook on future research possibilities and some recommendations for the further development of capital market models incorporating financial contagion.

Abstract: Stocks are exposed to the risk of sudden downward jumps. Additionally, a crash in one stock (or index) can increase the risk of crashes in other stocks (or indices). Our paper explicitly takes this contagion risk into account and studies its impact on the portfolio decision of a CRRA investor both in complete and in incomplete market settings. We find that the investor significantly adjusts his portfolio when contagion is more likely to occur. Capturing the time dimension of contagion, i.e. the time span between jumps in two stocks or stock indices, is thus of first-order importance when analyzing portfolio decisions. Investors ignoring contagion completely or accounting for contagion while ignoring its time dimension suffer large and economically significant utility losses. These losses are larger in complete than in incomplete markets, and the investor might be better off if he does not trade derivatives. Furthermore, we emphasize that the risk of contagion has a crucial impact on investors' security demands, since it reduces their ability to diversify their portfolios.

Work in Progress

  • Low-Frequency VIX and Equilibrium Option Pricing (with Roberto Marfé and Christian Schlag)

  • Portfolio Choice with Commodity ETFs (with Philipp Illeditsch and Christian Schlag)