Chris I. Telmer

Cyclical Dynamics in Idiosyncratic Labor Market Risk

Is individual labor income more risky in recessions? This is a difficult question to answer because existing panel data sets are so short. To address this problem, we develop a generalized method of moments estimator that conditions on the macroeconomic history that each member of the panel has experienced. Variation in the cross‐sectional variance between households with differing macroeconomic histories allows us to incorporate business cycle information dating back to 1930, even though our data do not begin until 1968. We implement this estimator using household‐level labor earnings data from the Panel Study of Income Dynamics. We estimate that idiosyncratic risk is (i) highly persistent, with an annual autocorrelation coefficient of 0.95, and (ii) strongly countercyclical, with a conditional standard deviation that increases by 75 percent (from 0.12 to 0.21) as the macroeconomy moves from peak to trough.

Affine Term Structure Models and the Forward Premium Anomaly

One of the most puzzling features of currency prices is the forward premium anomaly: the tendency for high interest rate currencies to appreciate. We characterize the anomaly in the context of affine models of the term structure of interest rates. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that nominal interest rates take on negative values with positive probability. We find the quantitative properties of either alternative to have important shortcomings. PERHAPS THE MOST PUZZLING FEATURE of currency prices is the tendency for high interest rate currencies to appreciate when one might guess, instead, that investors would demand higher interest rates on currencies expected to fall in value. This departure from uncovered interest parity, which we term the forward premium anomaly, has been documented in dozens—and possibly hundreds—of studies, and has spawned a second generation of papers attempting to account for it. One of the most inf luential of these is Fama ~1984!, who attributes the behavior of forward and spot exchange rates to a time-varying risk premium. Fama shows that the implied risk premium on a currency must ~1! be negatively correlated with its expected rate of depreciation and ~2! have greater variance. We refer to this feature of the data as an anomaly because asset pricing theory to date has been notably unsuccessful in producing a risk premium with the requisite properties. Attempts include applications of the capital asset pricing model to currency prices ~Frankel and Engel ~1984!, Mark ~1988!!, statistical models relating risk premiums to changing second moments ~Hansen and Hodrick ~1983!, Domowitz and Hakkio ~1985!, Cumby ~1988!!, and consumption-based asset pricing theories, including departures from time

Understanding European Real Exchange Rates

We study good-by-good deviations from the Law-of-One-Price (LOP) for over 1,800 retail goods and services between all European Union (EU) countries for the years 1975, 1980, 1985, and 1990. We find that for each of these years, after we control for differences in income and value-added tax (VAT) rates, there are roughly as many overpriced goods as there are underpriced goods between any two EU countries. We also find that good-by-good measures of cross-sectional price dispersion are negatively related to the tradeability of the good, and positively related to the share of non-traded inputs required to produce the good. We argue that these observations are consistent with a model in which retail goods are produced by combining a traded input with a non-traded input.

The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk

This paper investigates the welfare costs of business cycles in a heterogeneous agent, overlapping generations economy which is distinguished by idiosyncratic labor market risk. Aggregate variation arises both in terms of aggregate productivity shocks and countercyclical variation in the volatility of idiosyncratic shocks. Based on both aggregate data and microeconomic data from the Panel Study on Income Dynamics, we find the welfare benefits of eliminating aggregate variation to be large an order of magnitude larger than those originally documented by Lucas (1987). The key difference is countercyclical variation in idiosyncratic risk, which both amplifies the welfare cost of aggregate productivity shocks and imposes a cost of its own. The magnitude of these effects increases non-linearly in risk aversion. Our results support the increasingly popular notion that distributional effects are an important aspect of understanding the welfare cost of business cycles.

Monetary Policy and the Uncovered Interest Rate Parity Puzzle

High interest rate currencies tend to appreciate. This is the uncovered interest rate parity (UIP) puzzle. It is primarily a statement about short-term interest rates and how they are related to exchange rates. Short-term interest rates are strongly affected by monetary policy. The UIP puzzle, therefore, can be restated in terms of monetary policy. Do foreign and domestic monetary policies imply exchange rates that violate UIP? We represent monetary policy as foreign and domestic Taylor rules. Foreign and domestic pricing kernels determine the relationship between these Taylor rules and exchange rates. We examine different specifications for the Taylor rule and ask which can resolve the UIP puzzle. We find evidence in favor of a particular asymmetry. If the foreign Taylor rule responds to exchange rate variation but the domestic Taylor rule does not, the model performs better. A calibrated version of our model is consistent with many empirical observations on real and nominal exchange rates, including Famas negative correlation between interest rate differentials and currency depreciation rates.

Intergenerational Mobility and the Informative Content of Surnames

We propose an alternative method for measuring intergenerational mobility. Measurements obtained from traditional methods (based on panel data) are scarce, difficult to compare across countries and almost impossible to get across time. In particular, this means that we do not know how intergenerational mobility is correlated with growth, income or the degree of inequality. Our proposal is to measure the informative content of surnames in one census. The more information the surname has on the income of an individual, the more important is her background in determining her outcomes; and thus, the less mobility there is. The reason is that surnames provide information about family relationships because the distribution of surnames is necessarily very skewed. A large percentage of the population is bound to have a very unfrequent surname. For them the partition generated by surnames is very informative on family linkages. First, we develop a model whose endogenous variable is the joint distribution of surnames and income. There, we explore the relationship between mobility and the informative content of surnames. We allow for assortative mating to be a determinant of both. Second, we use our methodology to show that in large Spanish region the informative content of surnames is large and consistent with the model. We also show that it has increased over time, indicating a substantial drop in the degree of mobility. Finally, using the peculiarities of the Spanish surname convention we show that the degree of assortative mating has also increased over time, in such a manner that might explain the decrease in mobility observed. Our method allows us to provide measures of mobility comparable across time. It should also allow us to study other issues related to inheritance.

Interpreting the Forward Premium Anomaly

One of the central issues in international finance concerns the forward premium anomaly: changes in spot exchange rates are inversely related to the premium of forward rates over spot rates. The authors construct a numerical example of a theoretical economy with this property and discuss its potential as an explanation of the anomaly.

Currency Risk and Pricing Kernel Volatility

A basic tenet of lognormal asset pricing models is that a risky currency is associated with a low pricing kernel volatility. Empirical evidence implies that a risky currency is associated with a relatively high interest rate. Taken together, these two statements associate high-interest-rate currencies with low pricing kernel volatility. We document evidence suggesting that the opposite is true. We approximate the volatility of the pricing kernel with the volatility of the short interest rate. We find that, across currencies, relatively high interest rate volatility is associated with relatively high interest rates. This contradicts the prediction of lognormal models. One possible reason is that our approximation of the volatility of the pricing kernel is inadequate. We argue that this is unlikely, in particular for questions involving currencies. We conclude that lognormal models of the pricing kernel are inadequate for explaining currency risk and that future work should place increased emphasis on higher moments.

Prices as factors: Approximate aggregation with incomplete markets

Abstract Recent developments in intertemporal asset pricing theory focus on two sets of fundamental determinants of asset returns. Models with complete markets emphasize aggregate variables such as per capita consumption. Such models have not performed well empirically. Models with incomplete markets emphasize disaggregate variables such as the distribution of wealth. These models have shown empirical promise, but their lack of parsimony has led many to question their usefulness. Indeed, most empirical applications, as well as the best practice in the financial industry, ignore much of what theory has to say altogether. Practitioners favor factor models and, in particular, models in which asset returns serve as factors that explain other asset returns. This paper attempts to rationalize these very different approaches. We show that in an incomplete-markets economy—an economy in which the true pricing kernel is high dimensional and difficult to measure—a low-dimensional pricing kernel that depends on returns, as in the CAPM or the APT, can accurately price assets. In this sense, theory based on fundamentals admits an approximate aggregation that is consistent with practical application. Theory and practice, therefore, may not be as disparate as they might seem.

Asset Prices and Intergenerational Risk Sharing { the Role of Idiosyncratic Earnings Shocks ⁄

Abstract In their seminal paper, Rajnish Mehra and Edward Prescott (1985) were the first among many subsequent authors to suggest that non-traded labor-market risk may provide a resolution to the equity premium puzzle. The most direct demonstration of this was Constantinides and Duffie (1996) , who showed that, under certain conditions, cross-sectionally uncorrelated unit root shocks that become more volatile during economic contractions can resolve the puzzle. We examine the robustness of this to life-cycle effects. Retired people, for instance, do not face labor-market risk. If we incorporate them, to what extent will the equity premium be resurrected? Our answer is “not very much.” Our model, with realistic life-cycle features, can still account for about 75 percent of the average equity premium and the Sharpe ratio observed on the U.S. stock market.