Harjoat Singh Bhamra

The Aggregate Dynamics of Capital Structure and Macroeconomic Risk

We study the impact of time-varying macroeconomic conditions on optimal dynamic capital structure for a cross-section of firms. Our structural-equilibrium framework embeds a contingent-claim corporate financing model within a consumption-based asset-pricing model. We investigate the effect of macroeconomic conditions on asset valuation and optimal corporate policies, and of preferences on capital structure. While capital structure is pro-cyclical at dates when firms re-lever, it is counter-cyclical in aggregate dynamics, consistent with empirical evidence. We also find that financially constrained firms choose more pro-cyclical policies and that leverage accounts for most of the macroeconomic risk relevant for predicting defaults, but is a poor measure of how preferences impact capital structure. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Asset Prices with Heterogeneity in Preferences and Beliefs

In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have “catching up with the Joneses” utility functions and differ with respect to their beliefs (because of differences in priors) and their preference parameters for time discount, risk aversion, and sensitivity to habit. A key contribution of our paper is to demonstrate how one can obtain a closed-form solution to the consumption-sharing rule for agents who have both heterogeneous priors and heterogeneous preferences without restricting the risk aversion of the two agents to special values. We solve in closed form also for the the state-price density, the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; the term structure of interest rates; and the conditions necessary to obtain a stationary equilibrium in which both agents survive in the long run. The methodology we develop is sufficiently general that, as long as markets are complete, it can be used to obtain the sharing rule and state prices for models set in discrete or continuous time and for arbitrary endowment and belief updating processes.

A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets

We build a continous-time general equilibrium model of a two-country, pure-exchange economy featuring taxes on the repatriation of dividends. We find approximate closed-form expressions for asset prices, returns joint dynamics and equity portfolios, thus giving a full description of equilibrium in-between the polar cases of perfect integration and full segmentation. We show that large home bias in portfolios can result from small frictions on international financial markets. The reason is that, partly due to portfolio rebalancing, the international correlation of returns is very high - making assets close substitutes and implying that slight frictions have a dramatic effect on portfolio composition.

Stock Market Liberalization and the Cost of Capital in Emerging Markets

I study how stock market liberalization changes an emerging markets cost of capital. I do so in a Lucas economy with two dividend trees. One dividend tree represents the emerging markets dividends while the other tree represents the dividends paid by all other countries. I solve for equilibrium asset prices in two versions of the economy. In the first version, stock markets are partially liberalized, because the emerging markets residents cannot invest in foreign stock markets. All other agents are unconstrained. In the second version, stock markets are fully liberalized, because there are no investment constraints. I show that moving from partial to full liberalization causes an increase in the emerging markets cost of capital and risk premium, despite better international risk sharing.

Stochastic Idiosyncratic Operating Risk and Real Options: Implications for Stock Returns

We show that introducing stochastic idiosyncratic operating risk into an equity valuation model of firms with growth options explains two empirical results related to idiosyncratic volatility: the positive contemporaneous relation between stock returns and changes in idiosyncratic return volatility, and the poor performance of stocks with high idiosyncratic volatility. The model further predicts that (i) returns correlate positively with idiosyncratic volatility during intervals between large changes in idiosyncratic volatility (the switch effect), (ii) and that the return relations and the switch effect are stronger for firms with more real options and which undergo larger changes in idiosyncratic volatility. Empirical results support these predictions.

Does Household Finance Matter? Small Financial Errors with Large Social Costs

Households with familiarity biases tilt their portfolios toward a few risky assets. Consequently, household portfolios are underdiversified and excessively volatile. To understand the implications of underdiversification for social welfare, we solve in closed form a model of a stochastic, dynamic, general-equilibrium economy with a large number of heterogeneous firms and households that bias their investments toward a few familiar assets. We find that the direct mean-variance loss from holding an underdiversified portfolio that is excessively risky is equivalent to a reduction of 1.66% per annum in a households portfolio return, consistent with the estimate in Calvet, Campbell, and Sodini(2007). However, we show that in a more general model with intertemporal consumption, underdiversified portfolios increase consumption-growth volatility, amplifying the mean-variance losses by a factor of four. Moreover, in general equilibrium where growth is endogenous, underdiversified portfolios distort also aggregate investment and growth even when familiarity biases in portfolios cancel out across households. We find that the overall social welfare loss is about six times as large as the direct mean-variance loss. Our results illustrate that financial markets are not a mere sideshow to the real economy and that financial literacy, regulation, and innovation that improve the financial decisions of households can have a significant positive impact on social welfare.

Stochastic Idiosyncratic Cash Flow Risk and Real Options: Implications for Stock Returns

Stocks with high idiosyncratic volatility perform poorly relative to low idiosyncratic volatility stocks. We offer a novel explanation of this anomaly based on real options, which is consistent with earlier findings on idiosyncratic volatility (the positive contemporaneous relation between firm-level stock returns and idiosyncratic volatility). Our approach is based on introducing stochastic idiosyncratic cash flow risk into an equity valuation model of firms with growth options. Within our model, a firms systematic risk depends on the delta of its growth option. The growth options delta is lower when idiosyncratic volatility rises, driving down the firms systematic risk and hence its expected return – firms with higher idiosyncratic volatility therefore have lower expected returns. Our model additionally offers the following novel empirical predictions: (i) returns correlate positively with idiosyncratic volatility during intervals between large changes in idiosyncratic volatility (the switch effect), and (ii) the anomalies and the switch effect are stronger for firms with more real options and which undergo larger changes in idiosyncratic volatility. Empirical results support the predictions of our model.

Small Growth and Distress Returns: Two Sides of the Same Coin?

We propose a unified explanation for two seemingly disparate empirical findings: the negative abnormal returns of distressed stocks, and of small growth stocks. Based on a counterintuitive result relating option prices to jump risk (Merton 76), we show via an investment valuation model that higher idiosyncratic risks of sudden corporate failure simultaneously generate lower expected returns and higher valuation ratios among smaller firms. Consistent with the model, high failure risk traits characterize small growth stocks, and a failure risk factor subsumes small growth returns while explaining several asset pricing anomalies.

Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy

A common criticism of behavioral economics is that it has not shown that the psychological biases of individual investors lead to aggregate long-run effects on both asset prices and macroeconomic quantities. Our objective is to address this criticism by providing a simple example of a production economy where individual portfolio biases cancel when summed across investors, but still have an effect on aggregate quantities that does not vanish in the long-run. Specifically, we solve in closed form a model of a stochastic general-equilibrium production economy with a large number of heterogeneous firms and investors. Investors in our model are averse to ambiguity and so hold portfolios biased toward familiar assets. We specify this bias to be unsystematic so it cancels out when aggregated across investors. However, because of holding underdiversified portfolios, investors bear more risk than necessary, which distorts the consumption of all investors in the same direction. Hence, distortions in consumption do not cancel out in the aggregate and therefore increase the price of risk and distort aggregate investment and growth. The increased risk from holding biased portfolios, which increases the demand for the risk-free asset, leading to a higher equity risk premium and a lower risk-free rate that match the values observed empirically. Furthermore, all investors survive in the long-run, and so the effects of their biases never vanish. Our analysis illustrates that idiosyncratic behavioral biases can have long-run distortionary effects on both financial markets and the macroeconomy.