Alex C. Hsu

Financial Constraints, Monetary Policy Shocks, and the Cross-Section of Equity Returns

We analyze the impact of unanticipated monetary policy changes on equity returns and document that financially constrained firms earn a significantly lower return following rate increases as compared to unconstrained firms. Trading volume is significantly lower for constrained firms on FOMC announcement days but the differential return response manifests with a delay. Further, unanticipated increases in Federal funds rate are associated with a larger decrease in expected cash flow news, but not of discount rate news, for constrained firms relative to unconstrained firms. Our results highlight how monetary policy shocks have a disproportionate real impact on financially constrained firms.

Default Risk and the Pricing of U.S. Sovereign Bonds

United States Treasury securities are traditionally viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can always be repaid by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. This leads the latter to embed lower rate of recovery in case of default. We examine the relative pricing of nominal and inflation-indexed debt in the presence of risk of default. We show empirically that the breakeven inflation between nominal Treasury securities and TIPS is significantly related to the premium paid on U.S. credit default swaps (CDS), controlling for measures of liquidity and slow-moving capital. This evidence motivates us to model the prices of nominal and inflation-protected securities in a no-arbitrage setting. Our model shows that breakeven inflation is related to perceptions of differing rates of recovery in the two markets. The estimated model provides evidence that most of the TIPS mispricing after the crisis can be attributed to the exposure to default risk.

Implementing Stochastic Volatility in DSGE Models: A Comment

We highlight a state variable misspecification with one accepted method to implement stochastic volatility (SV) in DSGE models when transforming the nonlinear state-innovation dynamics to its linear representation. Although the technique is more efficient numerically, we show that it is not exact but only serves as an approximation when the magnitude of SV is small. Not accounting for this approximation error may induce substantial spurious volatility in macroeconomic series, which could lead to incorrect inference about the performance of the model. We also show that, by simply lagging and expanding the state vector, one can obtain the correct state-space specification. Finally, we validate our augmented implementation approach against an established alternative through numerical simulation.

The Decline in Asset Return Predictability and Macroeconomic Volatility

We document strong U.S. stock and bond return predictability from several macroeconomic volatility series before 1982, and a significant decline in this predictability during the Great Moderation. These findings are robust to alternative empirical specifications and out-of-sample tests. We explore the predictability decline using a model that incorporates monetary policy and shocks with time-varying volatility. The decline is consistent with changes in both policy and shock dynamics. While an increase in the response to inflation in the interest-rate policy rule decreases volatility, more persistent and less volatile shocks explain the lower predictability.

The Impact of Right-to-Work Laws on Worker Wages: Evidence from Collective Bargaining Agreements

We analyze the impact of the introduction of right-to-work (RTW) laws across the US on wages. After the introduction of RTW laws, there is a decrease in wages negotiated through collective bargaining agreements (CBAs). Further, the number of CBAs decreases, and the gap between the fraction of workers covered by a CBA and the fraction of union members increases. Firms increase investment and employment, and reduce their financial leverage. Our results suggest a decline in union bargaining power after RTW laws are passed, which could be a contributing factor to the recent slowdown in wage growth in the US. JEL Classification: J31, J41, J50, G30We analyze the economic and financial impact of right-to-work (RTW) laws in the US. Using data from collective bargaining agreements, we show that there is a decrease in wages for unionized workers after RTW laws. Firms increase investment and employment but reduce financial leverage. Labor-intensive firms experience higher profits and labor-to-asset ratios. Dividends and executive compensation also increase post-RTW. Our results are consistent with a canonical theory of the firm augmented with an exogenous bargaining power of labor and suggest that RTW laws impact corporate policies by decreasing that bargaining power.

Banking Structure and Monetary Policy Potency: Evidence from Firm-Level Investment

We find a significant increase in sensitivities of firm-level investment to monetary policy changes after interstate banking deregulation (IBD) in the U.S. The sensitivities are on average 2% more negative in the years following IBD compared to prior. The intensification of monetary policy potency is through the balance sheet channel of transmission. The result is driven entirely by firms with low external financing premium, characterized by low book leverage and high book-to-market ratio. Consistent with our empirical finding, when the financial accelerator is turned on in a calibrated DSGE model, the investment response to monetary policy shocks is amplified.

Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks

Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty increases risk and elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant risk premia in bad times, which in turn exacerbate the decline of macroeconomic aggregates and equity prices. Moreover, uncertainty is a priced risk factor in the cross-section of equity returns only when the factor exposure is a time-varying function of RA. In a model with endogenously time-varying RA, uncertainty produces large falls in investment and equity prices that closely match state-dependent data responses.Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty not only increases risk, but it also elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant risk premia in bad times, which in turn exacerbate the decline of macroeconomic aggregates and equity prices. Empirically, we document that local projection coefficients capturing the data response to the interaction of risk aversion and uncertainty are statistically significant and economically large. Indeed, heightened levels of RA during the 2008 crisis amplified the drop in output and investment by 41% and 28%, respectively, at the recession trough. Theoretically, we show that a New-Keynesian model with endogenously time-varying risk aversion via Campbell and Cochrane (1999) can produce large falls in output and investment close to matching their data counterparts following positive uncertainty shocks.

Real and Nominal Equilibrium Yield Curves: Wage Rigidities and Permanent Shocks

The links between real and nominal bond risk premia and macroeconomic dynamics are explored quantitatively in a model with nominal rigidities and monetary policy. The estimated model captures macroeconomic and yield curve properties of the U.S. economy, implying significantly positive real term and inflation risk bond premia. In contrast to previous literature, both premia are positive and generated by wage rigidities as a compensation for permanent productivity shocks. Stronger policy-rule responses to inflation (output) increase (decrease) both premia, while policy surprises generate negligible risk premia. Empirical evidence of the economic mechanism is provided.

The Decline of Macroeconomic Volatility Risk and Asset Return Predictability: Monetary Policy or Shocks?

We document a strong predictive power of macroeconomic volatility series for stock and bond returns before 1980, and a significant decline in this power during the Great Moderation. We explore these findings using an equilibrium model with monetary policy and several shocks with time-varying volatility. The model captures the return predictability observed in pre-1980 data, while matching salient properties of U.S. macroeconomic and financial data. The decline in return predictability is consistent with changes in both monetary policy and shock dynamics. While an increase in the response to inflation in the interest-rate policy rule reduces macroeconomic volatility, more persistent cost-push shocks with reduced variation in volatility explain the decline in return predictability.

Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

Fiscal policy matters for bond risk premia. Empirically, government spending level and volatility predict excess bond returns. Shocks to government spending level and volatility are also priced in the cross-section of bond and stock portfolios. Theoretically, level shocks raise inflation when marginal utility is high, thus generating positive inflation risk premia (term structure level effect). Volatility shocks steepen the yield curve (slope effect), producing positive term premia. These effects are consistent with evidence from a structural VAR. Further, asset pricing tests using model simulated data corroborate our empirical findings. Lastly, fiscal shocks are amplified at the zero lower bound.