Investment and asset pricing in a world of satisficing agents (with P. Bossaerts and G. Ugazio)
Swiss Finance Institute Research Paper No. 24-05
In 1955, Herbert Simon proposed that economic agents do not optimize, but instead satisfice: they optimize up to some point of satisfaction. But Simon did not provide a formal model. Here, we develop a formal theory of a satisficing investor and consequent financial market equilibrium borrowing a technique from robust control in engineering, namely, Model Reference Based Adaptive Control (MRAC). Instead of optimizing a portfolio in terms of, say, a mean-variance trade off, the MRAC agent chooses portfolios that generate return distributions that minimize surprise with respect to a desired reference distribution. Surprisingly, the satisficing agent mostly acts “as if” optimizing, but we discover important – and realistic – deviations, such as willingness to accept risk even in the absence of a risk premium. This also implies that asset pricing may at times differ substantially from traditional theory. We motivate our modeling approach not only by pointing to benefits of robustness (robust control), but also with reference to recent developments in behavioral economics and decision neuroscience.
Volatility during the COVID-19 pandemic (with J. Detemple and M. Rindisbacher)
Swiss Finance Institute Research Paper No. 23-95
We examine the impact of COVID-19 on market volatility in an equilibrium framework. The model combines beliefs-dependent preferences for economic dynamics and a stochastic SEIRD model with unpredictable birth/vaccine events and mitigating policies for disease propagation. The estimated model explains the realized trajectories of the S&P 500 volatility and number of new cases, identifies the source and composition of the volatility spike, while providing a good match for 25 unconditional moments of economic series. Beliefs-dependence is critical for this comprehensive explanation of short- and long-run properties. A model comparison study is performed. Mitigation policies are examined.
The economics of sustainability-linked bonds (with L. Engelhardt, R. Gibson and P. Krueger)
Swiss Finance Institute Research Paper No. 22-26
We develop a framework to understand the incentive structure and pricing of sustainability-linked bonds (SLBs). It provides conditions under which SLBs are incentive compatible for firms. We propose a novel mispricing measure for SLBs. Using the model and mispricing measure, we derive and test several empirical predictions. We show that overpriced SLBs experience negative returns in the secondary market after issuance. When firms issue overpriced SLBs, the stock price reaction at issuance is significantly positive, consistent with a wealth transfer from bond- to shareholders. Finally, we document a significant nonlinear relationship between the mispricing measure and firms' ESG ratings.
Can the variance after-effect distort stock returns?
Swiss Finance Institute Research Paper No. 21-16
Variance after-effect is a perceptual bias in the dynamic assessment of variance. Experimental evidence shows that perceived variance is decreased after prolonged exposure to high variance and increased after exposure to low variance. We introduce this effect in an otherwise standard financial model where information about variance is incomplete and updated sequentially. We introduce a variance after- effect adjustment factor in a bayesian learning model and derive the associated predictive variance. We show theoretically how this adjustment factor affects both average and volatility of excess returns. We construct a proxy of the adjustment factor using the sequence of dispersion of analysts earnings forecast. We provide empirical evidence using US stock data over the sample 1982 - 2019, that fluctuations in this measure are significantly and positively related to excess volatility as predicted by the model. Further confirming the model's implications, we also show how stock returns are positively impacted by the adjustment factor and construct long short strategies that generate significant positive alpha with respect to the Fama-French 5 factor model.
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Swiss Finance Institute Research Paper No. 24-05
In 1955, Herbert Simon proposed that economic agents do not optimize, but instead satisfice: they optimize up to some point of satisfaction. But Simon did not provide a formal model. Here, we develop a formal theory of a satisficing investor and consequent financial market equilibrium borrowing a technique from robust control in engineering, namely, Model Reference Based Adaptive Control (MRAC). Instead of optimizing a portfolio in terms of, say, a mean-variance trade off, the MRAC agent chooses portfolios that generate return distributions that minimize surprise with respect to a desired reference distribution. Surprisingly, the satisficing agent mostly acts “as if” optimizing, but we discover important – and realistic – deviations, such as willingness to accept risk even in the absence of a risk premium. This also implies that asset pricing may at times differ substantially from traditional theory. We motivate our modeling approach not only by pointing to benefits of robustness (robust control), but also with reference to recent developments in behavioral economics and decision neuroscience.
Volatility during the COVID-19 pandemic (with J. Detemple and M. Rindisbacher)
Swiss Finance Institute Research Paper No. 23-95
We examine the impact of COVID-19 on market volatility in an equilibrium framework. The model combines beliefs-dependent preferences for economic dynamics and a stochastic SEIRD model with unpredictable birth/vaccine events and mitigating policies for disease propagation. The estimated model explains the realized trajectories of the S&P 500 volatility and number of new cases, identifies the source and composition of the volatility spike, while providing a good match for 25 unconditional moments of economic series. Beliefs-dependence is critical for this comprehensive explanation of short- and long-run properties. A model comparison study is performed. Mitigation policies are examined.
The economics of sustainability-linked bonds (with L. Engelhardt, R. Gibson and P. Krueger)
Swiss Finance Institute Research Paper No. 22-26
We develop a framework to understand the incentive structure and pricing of sustainability-linked bonds (SLBs). It provides conditions under which SLBs are incentive compatible for firms. We propose a novel mispricing measure for SLBs. Using the model and mispricing measure, we derive and test several empirical predictions. We show that overpriced SLBs experience negative returns in the secondary market after issuance. When firms issue overpriced SLBs, the stock price reaction at issuance is significantly positive, consistent with a wealth transfer from bond- to shareholders. Finally, we document a significant nonlinear relationship between the mispricing measure and firms' ESG ratings.
Can the variance after-effect distort stock returns?
Swiss Finance Institute Research Paper No. 21-16
Variance after-effect is a perceptual bias in the dynamic assessment of variance. Experimental evidence shows that perceived variance is decreased after prolonged exposure to high variance and increased after exposure to low variance. We introduce this effect in an otherwise standard financial model where information about variance is incomplete and updated sequentially. We introduce a variance after- effect adjustment factor in a bayesian learning model and derive the associated predictive variance. We show theoretically how this adjustment factor affects both average and volatility of excess returns. We construct a proxy of the adjustment factor using the sequence of dispersion of analysts earnings forecast. We provide empirical evidence using US stock data over the sample 1982 - 2019, that fluctuations in this measure are significantly and positively related to excess volatility as predicted by the model. Further confirming the model's implications, we also show how stock returns are positively impacted by the adjustment factor and construct long short strategies that generate significant positive alpha with respect to the Fama-French 5 factor model.
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