Consumption Decisions under Uncertainty

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate in this data. Our findings imply that standard monetary models miss an essential link between the central bank instrument and the economic activity that monetary policy is intended to affect, and thus we call for a new approach to monetary policy analysis. We sketch a new approach using an economic model based on our pricing kernel. The model incorporates the key relationships between policy and risk movements in an unconventional way: the central bank's policy changes are viewed as primarily intended to compensate for exogenous business cycle fluctuations in risk that threaten to push inflation off target. This model, while an improvement on standard models, is considered just a starting point for their revision. It leads to critical questions that researchers need to answer as they continue to revise their approach to monetary policy analysis. Copyright © 2009 by the National Bureau of Economic Research.

References and Further Reading

IT is quite common to discuss interest theory and influence of a controlled rate of interest on economy in terms of rate of interest, assuming some definite, and often fixed, relationship among various types of rates. Lord Keynes, for example, referred to the complex of rates of interest on loans of various maturities and risks. 1 Dr. J. R. Hicks, in a later work,2 also speaks of rate; thus, he states that rates will differ some sort of 'normal' risk-premium, whose size will depend upon estimate put upon gain in security (p. I50I). Yet, even most superficial inspection of interest rate data will show that various complexes do not move together. Particularly is this true of various risks within same time (or maturity) category. Moreover, there is no logical reason for concordant movement to rule all time. Borrowing from Hicks, we may say that variations in rate of interest among loans of same duration are caused by differences in risk of default by borrower, I or, rate for each loan of a given duration is pure rate of interest plus a risk-premium. To a great extent, this risk element is a subjective valuation of lender; that is, it is a measure of how certain he feels that loan will be repaid.4 Hence, if lender feels cheerful, he is likely to believe risk element less than if in a more disagreeable frame of mind. fairly well established fact is that community in general, and lenders in particular, feel more optimistic in prosperity than in a depression.5 Applying this statement to risk premium, we would expect it to decrease in prosperity and increase in a depression. In other words, spread between safest investments and riskier ones would tend to narrow as boom proceeds, and widen as times become worse. Thus, complex of interest rates is highly unstable, and we must be careful in regard to rates we are discussing. Rates on safe investments will fall in depression, particularly after passing of panic phase, but rates on risky investments may well rise. Hence, to state that rate of interest falls in this case is erroneous; some rates fall, while others rise, or fall less. Implied in preceding paragraph is difficulty of government manipulation of rate of interest, particularly current cheapmoney policy. All that may result from such interference is a low rate of return of triple A securities, but an increase in risk-premium on riskier securities, notably those representing new investment, whose revival may be chief aim of such a policy. If this interference creates fears among investing class, either as to future interest rates being higher after cheap-money policy is ended, thus depressing capital value of older securities, or simply a reluctance to invest because of political opposition to such governmental policy, then risk premium will almost certainly rise pari passu with fall in yields of safe investments.

Introduction. In contrast to the markets of developed countries, forming characteristic risk premium investment bonds in emerging markets, is that the greatest effect on the risk premium on bonds in countries such factor provides market liquidity in general and specific securities in particular. The second most significant factor influencing the risk premium is the risk of changing interest rates. The risk of default of issuers in such countries is also quite high, but the component of creditworthiness is less significant factor in the combination of systematic risks. Due to low sovereign ratings of Ukraine, the credit ratings of bonds of all domestic issuers have a speculative level. Owing to this fact, all of them can be classified as highly risky and, accordingly, highly profitable (HighYield Bonds). Purpose. The aim of the article is to reduce deficits in the scientific and methodological provision of the use of corporate bonds instruments on the basis of determining the determinants of the premium for the risk of investing in them. Method (methodology). To achieve the goal and solve the problems, the following methods have been used: method of analysis and synthesis, method of comparison and generalization; method of empirical research and factor analysis; method of system approach and strategy. Results. The research of the determinants of the risk premium is important, first of all, from the point of view of substantiating the technologies of reducing the cost of enterprises to capital. The key causes of underdevelopment of the domestic corporate bond market have been determined. We have identified factors that influence the spread of profitability and the value of bonds. They are the risk of default of the issuer and the potential of the enterprise development (credit component); base interest rate and long-term interest rates on the financial market (interest rate component); liquidity of the capital market (component of liquidity); the level of inflation and the development of economic conditions; information risks. It has been determined that in order to reduce the risk of investments in corporate bonds, it is necessary to implement at the regulatory level a set of measures to reduce overhead costs and increase the reliability of investments. The introduction of a safety covenant system can be defrined as one of such measures.

This study determines optimal portfolios of five major U.S. financial assets based on four performance measures consistent with modern portfolio theory and the Capital Asset Pricing Model, and analyzes their risk-return profiles, over different investment horizons. Intermediate-term government bonds offer the best tradeoff between the risk premium and systematic risk, while small company stocks provide the highest risk premium adjusted for systematic risk, for all investment periods. Diversified portfolios containing mainly intermediate-term government bonds, with smaller allocations to small and large company stocks, generally deliver the best tradeoff between the risk premium and total risk as well as the highest risk premium adjusted for total risk. These diversified optimal portfolios hold declining proportions of intermediate-term government bonds and rising allocations of small and large company stocks, for longer investment horizons. All the optimal portfolios identified by the different performance measures offer substantially better risk-adjusted performance over longer periods. Keywords Performance Measures, Optimal Portfolios, Risk-Return Tradeoff, Investment Horizon

Abstract. The objective of this article is theoretical and methodological justifying of determining algorithm of the cost of debt capital for enterprises functioning in emerging markets (EM). The methods of research: analysis and synthesis, system analysis, comparative analysis, empirical and statistical methods, factor analysis. Results. In this article key determinants of interest rates on debt capital for enterprises and their impact on the procedure of discount rate calculation are determined. The issue of the cost of debt calculation of enterprises in condition of absence of complete information concerning systematic and non-systematic crediting risks is studied. Differences between interest rate on the loan fixed in credit agreement and expected by creditors the cost of debt are identified. It is determined that the key factor impacting the deviation level of market value of debt capital from the nominal, and respectively, deviation of the cost of debt from the cost of capital is probability of default (PD). At the minimum values of PD, the contract interest rate corresponds to the rate of cost of debt and it is advisable to use it for discount rate calculation. Critical analysis of alternative methodological approaches of the cost of debt calculation is made. Ways of integrating of market information concerning credit default swaps into the process of expected cost of debt calculation are justified. Factors of shadowing of rates of the cost of debt and ways of reducing of shadow transactions’ level in the credit market are identified. Conclusions. At high PD values, expected by market premium for default risk may exceed the contract interest rate, which necessitates constant monitoring of credit risks and appropriate adaptation of interest rates. In the paper the algorithm of such adaptation are proposed. It is shown that in the case of non-use of interest rates adjustment taking into account changes in PD, CDS and LGD, premium for creditors’ systematic risk can differ significantly from market values of similar enterprises (peer-group), and estimated value of the cost of debt can acquire negative values. Contract (promised) interest rate should be set in such way that the premium for systematic risk of providing debt capital will be at the level of similar companies and does not change significantly as a result of probability of default changes. If in practice the opposite situation occurs, it is the evidence of contract interest rate shadowing, absence of effective system of assessment and management of credit risks. For solving the problem of interest rate transparency and filling of information gaps concerning PD borrowers in EM countries, should intensify CDS market. Keywords: debt capital, default probability, non-performing loans, credit default swap, credit spread, debt capital premium, shadow economy. JEL Classification E47 Formulas: 16; fig.: 0; tabl.: 3; bibl.: 15.

This paper develops a matrix-measure of multivariate risk aversion which is related to a notion of risk premium and states the restrictions that must be imposed upon the matrix-measures of two utility functions in order that one require a higher risk premium than another for every small multivariate risk. A necessary and sufficient condition for comparability of global attitude towards risk is that the local restrictions hold over the entire domain. The usefulness of the measures of risk aversion is discussed within the context of a multivariate risk-sharing problem. UNIVARIATE MEASURES OF ABSOLUTE and relative risk aversion were introduced in the seminal works of Pratt [8] and Arrow [1], and have since become indispensable tools for the analysis of risk bearing in situations involving unidimensional risks. Recent years witnessed numerous attempts to generalize various aspects of the Pratt-Arrow notions to the case of multivariate risk (Kihlstrom and Mirman [6], Keeney [5], Duncan [2], Paroush [7], and Stiglitz [9]). The univariate case is qualitatively different from the multivariate case in that the ordinal preferences of all decision makers are identical, whereas in the multivariate case the preference orderings may differ among decision makers. This fact has two important consequences. First, while the analysis of risk bearing in situations involving univariate risks turns out to depend solely upon the cardinal properties of the function representing the ordinal preferences of the decision makers involved, in situations involving multivariate risks, the ordinal preferences themselves play an important role in addition to that of the function representing them. Second, in the univariate case the local measure of absolute risk aversion permits a complete ordering of individuals according to the relation least as risk averse as, whereas in the multivariate case such ordering is not in general independent of the specific risk under consideration. Pratt [8] has shown that the univariate measure of absolute risk aversion satisfies a formal relation to a number which has the interpretation of risk premium. In this study I introduce a matrix measure of absolute multivariate risk aversion which satisfies a similar formal criterion. It should be noted at the outset, however, that in the multivariate case the risk premium may be regarded as a vector of commodities (see, for example, Duncan [2, 3]), and interpersonal comparison of risk aversion is not directional independent. I.e., the ranking of risk

This paper investigates the relation between the conditional expected equity risk premium and the slope of the term structure of interest rates. Theoretically, these variables are linked, the relation may be nonlinear, and negative risk premiums are consistent with equilibrium. Given these implications, we employ a nonparametric estimation technique to document the empirical relation between the risk premium and the slope of the term structure using almost two hundred years of data. Of particular interest, the risk premium is increasing in the term structure slope; however, for either small or negative slopes, the risk premium is much more sensitive to changes in interest rates. In addition, the empirical results imply negative expected equity risk premiums for some inverted term structures. Finally, variations in the risk premium do not appear to be related to variations in the variance of equity returns. We illustrate these features in a stylized consumption-based model, and provide the economic intuition behind the results.

Interest rate forecasts, state price densities and risk premium from Euribor options

Management Insights

This research aims to test the overreaction anomaly of winner portfolios and loser portfolios on capital market performance before and during the COVID-19 pandemic and test the influence of winner portfolios, loser portfolios and optimal portfolios on capital market performance as well as including ROE, DER, inflation, exchange rates and interest rates as control variables. The first stage of testing uses the event study method. The second stage of the model uses panel data regression. The data used were 26 LQ45 companies on the Indonesia Stock Exchange from September 2019 – August 2020. The results of this research found that in the first stage no overreaction anomaly was found. The second stage in the panel data regression is that the dependent variable has a positive effect on the winner portfolio, the loser portfolio has a negative effect and the optimal portfolio has no effect. ROE in the winner, loser and optimal models has a positive effect, DER has a positive effect in the winner group, while in the loser group there is no effect, in the optimal group DER has a negative effect. Inflation has a positive effect in the winner, loser and optimal groups. The exchange rate has no effect in the winner and loser groups, while in the optimal group the exchange rate has a negative effect. Interest rates have a positive effect on capital market performance. This research only examines events before and during the COVID-19 pandemic, for next research period can be extended and samples does not group companies into groups of large asset companies and small asset companies. This research provides an overview and is useful in decision making for investors and managers. This research model tries to complement financial ratios with several micro and macro variables that have an influence on capital market performance before and during the COVID-19 pandemic.

The risk premium and the probability premium are used to determine appropriate coefficients of absolute risk aversion under CARA utility. A defensible range of risk aversion coefficients is defined by the coefficients that correspond to risk premiums falling between 1 and 99% of the amount at risk or to probability premiums falling between .005 and .49 for a lottery that pays or loses a given sum. The consequences of ignoring risk premiums when selecting risk-aversion coefficients for representative decision makers are illustrated by calculation of the implied risk premium associated with the levels of absolute risk aversion assumed in six selected studies.

The space of probability distributions on a given sample space possesses natural geometric properties. For example, in the case of a smooth parametric family of probability distributions on the real line, the parameter space has a Riemannian structure induced by the embedding of the family into the Hilbert space of square-integrable functions, and is characterised by the Fisher-Rao metric. In the nonparametric case the relevant geometry is determined by the spherical distance function of Bhattacharyya. In the context of term structure modelling, we show that minus the derivative of the discount function with respect to the maturity date gives rise to a probability density. This follows as a consequence of the positivity of interest rates. Therefore, by mapping the density functions associated with a given family of term structures to Hilbert space, the resulting metrical geometry can be used to analyse the relationship of yield curves to one another. We show that the general arbitrage-free yield curve dynamics can be represented as a process taking values in the convex space of smooth density functions on the positive real line. It follows that the theory of interest rate dynamics can be represented by a class of processes in Hilbert space. We also derive the dynamics for the central moments associated with the distribution determined by the yield curve.

The role of longevity bonds in optimal portfolios