Deborah Lucas

Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk

Using cross-sectional data from the SCF and Tax Model, we show that entrepreneurial income risk has a significant influence on portfolio choice and asset prices. We find that households with high and variable business income hold less wealth in stocks than other similarly wealthy households, although they constitute a significant fraction of the stockholding population. Similarly for nonentrepreneurs, holding stock in the firm where one works reduces the portfolio share of other common stocks. Finally, we show that adding proprietary income to a linear asset pricing model improves its performance over a similar model that includes only wage income. Copyright The American Finance Association 2000.

Portfolio Choice in the Presence of Background Risk

In this paper, we focus on how the presence of background risks--from sources such as labour and entrepreneurial income--influences portfolio allocations. This interaction is explored in a theoretical model that is calibrated using cross-sectional data from a variety of sources. The model is shown to be consistent with some but not all aspects of cross-sectional observations of portfolio holdings. The paper also provides a survey of the extensive theoretical and empirical literature on portfolio choice.

MARKET FRICTIONS, SAVINGS BEHAVIOR, AND PORTFOLIO CHOICE

We examine a decision theoretic model of portfolio choice in which investors face income risk that is not directly insurable. We consider the sensitivity of savings and portfolio allocation rules to different assumptions about utility, the stochastic process for income and asset returns, and market frictions (transactions costs and short-sale constraints). Under CRRA time additive utility, habit persistence utility, and for a broad range of parameterizations, the model predicts that investors wish to borrow and invest all of their savings in stocks. This qualitative implication is robust to the introduction of significant transaction costs in the stock market, and contrasts sharply with portfolio allocation models in which there is no labor income.

Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle

Abstract This paper studies asset prices and consumption patterns in an infinite horizon model with borrowing constraints and uninsurable idiosyncratic shocks to labor income. Calibration experiments demonstrate that idiosyncratic shocks to income are effectively smoothed through transactions in the securities market; consumption and asset prices are similar to those predicted in the representative agent model. This suggests that the equity premium puzzle is robust to several important sources of market incompleteness.

Stock Prices and Fundamentals

We consider a variety of fundamentals-based explanations for the recent stock price run-up, including changes in preferences, dividend growth rates, and the extent of risk sharing. In a calibrated OLG model we focus on two aspects of risk sharing-the market participation rate and the degree of diversification. We conclude that the relatively small changes in participation that have occurred over this decade are unlikely to be a major part of the explanation. Increased portfolio diversification, however, is likely to have had a larger effect. There is empirical evidence that households have significantly diversified their portfolios, selling individual stocks and buying mutual funds. An important difference between poorly diversified portfolios and investment in a market index is the reduced likelihood of catastrophic outcomes. When this is reflected in model parameters, the expected equity premium falls by more than 4%. More generally, we construct scenarios that are loosely consistent with the data in which the required return on stocks falls by 2%. Using a calibrated Gordon growth model, we find that this change in expected returns goes at least halfway towards justifying the current high level of the price-dividend ratio in the U.S. stock market.

Equity Issues with Time-Varying Asymmetric Information

This paper develops a formal model of the effect of time-varying asymmetric information on the timing and pricing of equity issues when managers are better informed than outside investors. We assume that as time passes, the adverse selection problem becomes more severe as more managers receive a private signal. Under this assumption, the model predicts temporal variation in the quantity of issues, with a bunching of issues after information releases. It also predicts that the price drop at issue announcement increases with the time since the last information release. These predictions are consistent with several recent empirical studies relating equity issues to earnings and dividend announcements.

The Variability of Velocity in Cash-in-Advance Models

Monetary models based on cash-in-advance constraints make strong predictions about the stochastic properties of endogeneous variables such as the velocity of circulation of money, the rate of inflation, and real and nominal interest rates. We develop numerical methods to understand these predictions because the models cannot be characterized analytically. We calibrate some cash-in-advance models using driving processes estimated from U. S. time-series data to generate model predictions that are compared to sample statistics. Formulations of the models that generate variability in velocity corresponding to the U.S. data typically fail along other dimensions.

Heterogeneity and Portfolio Choice: Theory and Evidence

In this paper, we summarize and add to the evidence on the large and systematic differences in portfolio composition across individuals with varying characteristics, and evaluate some of the theories that have been proposed in terms of their ability to account for these differences. Variation in background risk exposure from sources such as labor and entrepreneurial income or real estate holdings, and from factors such as transactions costs, borrowing constraints, restricted pension investments and life cycle considerations – can explain some but not all aspects of the observed cross-sectional variation in portfolio holdings in a traditional utility maximizing framework. In particular, fixed costs and life cycle considerations appear necessary to explain the lack of stock market participation by young and less affluent households. Remaining challenges for quantitative theories include the apparent lack of diversification in some unconstrained individual portfolios, and non-participation in the stock market by some households with significant financial wealth.

Shareholder Heterogeneity, Adverse Selection, and Payout Policy

When shareholders have different plans to sell their shares, they will, in general, have different preferences concerning the firms decision to pay out cash using dividends or share repurchase. We illustrate these different preferences and explore a model of payout policy that highlights the adverse selection costs of repurchases when managers have superior information about the value of the firm. We show that, in the absence of fixed costs to repurchasing shares, there is a separating equilibrium in which managers use taxable dividends to signal the quality of the firm, with better firms paying lower dividends, using repurchases for the remainder of the payout. With fixed costs to repurchasing, small payouts are made via dividend and large payouts are divided between repurchases and dividends, as in the no-fixed cost case. In both cases, the percentage of shares repurchased increases with the size of the payout and larger repurchases are better news.

Bank Financing and Investment Decisions with Asymmetric Information about Loan Quality

Banks know more about the quality of their assets than do outside investors. This informational asymmetry can distort investment decisions if the bank must raise funds from uninformed outsiders. We model the effect of asymmetric information about loan quality on the asset and liability decisions of banks and the market valuation of bank liabilities. The existence of a precautionary demand for riskless securities against future liquidity needs depends on both the regulatory environment and the informational structure. If banks are ex ante identical, they prefer issuing risky debt to fund a withdrawal to holding riskless securities ex ante. If banks have partial knowledge of loan quality, however, high quality banks may hold riskless securities to signal their quality, enabling them to issue risky debt at a lower interest rate. We present new empirical evidence that banks with higher asset quality do in fact hold more cash and securities.