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"Constantinides, George M"
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Asset Pricing with Countercyclical Household Consumption Risk
We show that shocks to household consumption growth are negatively skewed, persistent, countercyclical, and drive asset prices. We construct a parsimonious model where heterogeneous households have recursive preferences. A single state variable drives the conditional cross-sectional moments of household consumption growth. The estimated model fits well the unconditional cross-sectional moments of household consumption growth and the moments of the risk-free rate, equity premium, price-dividend ratio, and aggregate dividend and consumption growth. The model-implied risk-free rate and price-dividend ratio are procyclical, while the market return has countercyclical mean and variance. Finally, household consumption risk explains the cross section of excess returns.
Journal Article
Mispriced index option portfolios
In model-free out-of-sample tests, we find that the optimal portfolio of a utility maximizing investor trading in the S&P500 Index, cash, and index options bought at ask and written at bid prices stochastically dominates the optimal portfolio without options and yields returns with higher mean and lower volatility in most months from 1990 to 2013. Unlike earlier claims of overpriced puts, our portfolios include mostly short calls and are particularly profitable when maturity is short and volatility is high. Similar results are obtained with the CAC and DAX indices. Neither priced factors nor a nonmonotonic stochastic discount factor explains the excess returns.
Journal Article
Asset Pricing
Young people would like to invest in equities, given the observed high equity premium. However, they are reluctant to reduce their current consumption in order to save by investing in stocks, because the bulk of their lifetime income comes from their wages in their middle age. They want to borrow against their future income, but the borrowing constraints prevent them from doing so. Human capital alone cannot be used as collateral for large loans in modern economies for reasons of moral hazard and adverse selection. The model explains why many consumers do not participate in the stock market when they are young. Middle-aged consumers earn income that they partly consume and partly save by purchasing equities and bonds. The old earn no income and consume their savings. Therefore, the risk of stock and bond ownership is concentrated in the hands of middle-aged consumers who save. This concentration of risk generates the high equity premium and the demand for bonds, in addition to the demand for shares by the middle-aged. The model acknowledges and addresses at the same time the issue of the limited participation in the stock market and the demand for bonds. [web URL: http://www.journals.uchicago.edu/doi/full/10.1086/694621]
Journal Article
Mispricing of S&P 500 Index Options
Widespread violations of stochastic dominance by 1-month S&P 500 index call options over 1986-2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although precrash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data. Substantial violations by postcrash OTM calls contradict the notion that the problem lies primarily with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the postcrash period of 1988-1995 is followed by a substantial increase over 1997-2006, which may be due to the lower quality of the data but, in any case, does not provide evidence that the options market is becoming more rational over time.
Journal Article
Are Options on Index Futures Profitable for Risk-Averse Investors? Empirical Evidence
American options on the S&P 500 index futures that violate the stochastic dominance bounds of Constantinides and Perrakis (2009) from 1983 to 2006 are identified as potentially profitable trades. Call bid prices more frequently violate their upper bound than put bid prices do, while violations of the lower bounds by ask prices are infrequent. In out-of-sample tests of stochastic dominance, the writing of options that violate the upper bound increases the expected utility of any risk-averse investor holding the market and cash, net of transaction costs and bid-ask spreads. The results are economically significant and robust.
Journal Article
Habit Formation: A Resolution of the Equity Premium Puzzle
The equity premium puzzle, identified by Mehra and Prescott, states that, for plausible values of the risk aversion coefficient, the difference of the expected rate of return on the stock market and the riskless rate of interest is too large, given the observed small variance of the growth rate in per capita consumption. The puzzle is resolved in the context of an economy with rational expectations once the time separability of von Neumann-Morgenstern preferences is relaxed to allow for adjacent complementarity in consumption, a property known as habit persistence. Essentially habit persistence drives a wedge between the relative risk aversion of the representative agent and the intertemporal elasticity of substitution in consumption.
Journal Article
Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence
We present evidence that the equity premium and the premium of value stocks over growth stocks are consistent in the 1982–96 period with a stochastic discount factor calculated as the weighted average of individual households’ marginal rate of substitution with low and economically plausible values of the relative risk aversion coefficient. Since these premia are not explained with an SDF calculated as the per capita marginal rate of substitution with a low value of the RRA coefficient, the evidence supports the hypothesis of incomplete consumption insurance. We also present evidence that an SDF calculated as the per capita marginal rate of substitution is better able to explain the equity premium and does so with a lower value of the RRA coefficient, as the definition of asset holders is tightened to recognize the limited participation of households in the capital market.
Journal Article
Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle
Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlapping-generations economy in which consumers are subject to a borrowing constraint. The key feature captured by the OLG economy is that the bulk of the future income of the young consumers is derived from their wages forthcoming in their middle age, while the bulk of the future income of the middle-aged consumers is derived from their savings in equity and bonds. The young would like to borrow and invest in equity but the borrowing constraint prevents them from doing so. The middle-aged choose to hold a diversified portfolio that includes positive holdings of bonds, and this explains the demand for bonds. Without the borrowing constraint, the young borrow and invest in equity, thereby decreasing the mean equity premium and increasing the rate of interest.
Journal Article