Gregory Phelan

Global Collateral: How Financial Innovation Drives Capital Flows and Increases Financial Instability

We show that cross-border financial flows arise when levels of financial innovation differ across countries. Financial integration is a way of sharing scarce collateral. The ability of one country to leverage and tranche assets provides attractive financial contracts to investors in the other country, and general equilibrium effects on prices create opportunities for investors in the sophisticated country to invest abroad. Foreign demand for collateral and for collateral-backed financial promises increases the collateral value of domestic assets, and cheap foreign assets provide attractive returns to investors who do not demand collateral to issue promises. Gross global flows respond dynamically to fundamentals, exporting and amplifying financial volatility.

Hyperbolic Discounting and Life-Cycle Portfolio Choice

This paper studies how hyperbolic discounting affects stock market participation, asset allocation, and saving decisions over the life cycle in an economy with Epstein-Zin preferences. Hyperbolic discounting affects saving and portfolio decisions through at least two channels: (1) it lowers desired saving, which decreases financial wealth relative to future earnings; and (2) it lowers the incentive to pay a fixed cost to enter the stock market. We find that hyperbolic discounters accumulate less wealth relative to their geometric counterparts and that they participate in the stock market at a later age. Because they have lower levels of financial wealth relative to future earnings, hyperbolic discounters who do participate in the stock market tend to hold a higher share of equities, particularly in the retirement years. We find that increasing the elasticity of intertemporal substitution, holding risk aversion constant, greatly magnifies the impact of hyperbolic discounting on all of the models decision rules and simulated levels of participation, allocation, and wealth. Finally, we introduce endogenous financial knowledge accumulation and find that hyperbolic discounting leads to lower financial literacy and inefficient stock market investment.

Securitized Markets, International Capital Flows, and Global Welfare

We study the effect of collateralized lending and securitization on the global supply of securitized assets, welfare, and international net and gross capital flows in a two country general equilibrium model with idiosyncratic investment risk. The financial sectors in the two countries, Home and Foreign, differ by the collateral requirement for investment loans, with Home requiring lower margins. In autarky, Home endogenously supplies more assets and enables more risk sharing. Upon financial integration, capital flows from Foreign to Home, leading to lower interest rates and an increase in the global supply of assets. Foreign enjoys substantial welfare gains through better risk sharing and portfolio reallocation, while the welfare experience for Home is ambiguous. Gross capital flows arise when agents face aggregate shocks to the expected payoff to investment projects, but can collapse when shocks concern the variance of returns.

Dimensionality and Disagreement: Asymptotic Belief Divergence in Response to Common Information

When information is of lower dimension than the model generating the data, Bayesian updating of marginal probabilities need not converge to the truth. Because the information is of lower dimension than the model, agents face an identification problem, affecting the role of data in inference. We provide conditions under which learning is asymptotically inconsistent with positive probability, and sometimes almost surely. Robustly, two agents with differing priors who observe identical, unambiguous data may disagree forever, with stronger disagreement the more data is observed. Agents use common observations to differentially update marginal beliefs about different parameters.

Debt Collateralization, Capital Structure, and Maximal Leverage

We study how allowing agents to use debt as collateral affects asset prices, leverage, and interest rates in a general equilibrium, heterogeneous-agent model with collateralized financial contracts and multiple states of uncertainty. In the absence of debt collateralization, multiple contracts are traded in equilibrium, with some agents borrowing using risky debt and others borrowing with risk-free debt. When agents can use debt contracts as collateral to borrow from other agents, margin requirements decrease, asset prices increase, and the interest rate on risky debt decreases. We characterize equilibrium for N states and L levels of debt collateralization and prove that enough levels of debt collateralization creates an equilibrium featuring maximal leverage on all debt contracts. In the dynamic model, debt collateralization creates larger asset price volatility.