Lei Lu

Asset Pricing in a Monetary Economy with Heterogeneous Beliefs

In this paper, we shed new light on the role of monetary policy in asset pricing by examining the case in which investors have heterogeneous expectations about future monetary policy. This case is realistic because central banks are typically less than perfectly open about their intentions. Accordingly, surveys of economists reveal that they frequently disagree in their expectations. Under heterogeneity in beliefs, investors place speculative bets against each other on the evolution of the money supply, and as a result the sharing of wealth in the economy evolves stochastically. Employing a continuous-time equilibrium model, we show that these fluctuations majorly affect the prices of all assets, as well as inflation. Our model could help explain some empirical puzzles. In particular, we find that the volatility of bond yields and stock market volatility could be significantly increased by the heterogeneity in beliefs, a conclusion supported by our empirical analyses. n nThis paper was accepted by Wei Xiong, finance.

Enforceability and the Effectiveness of Laws and Regulations

Controlling shareholders in China can divert assets from listed firms or coerce firms to serve as guarantors on questionable loans. A new rule was enacted prohibiting diversion for ‘non-operational’ purposes, and firms complying with this rule experienced a reduction in related party transactions, an increase in investment and dividends, and better performance. Another contemporary rule aimed to standardize practice of firms providing loan guarantees, but had no impact on firms. Our results highlight the importance of enforceability: laws and regulations that can be enforced at lower costs are more likely to succeed, especially in countries with weak formal institutions.

Asset Pricing and Welfare Analysis with Bounded Rational Investors

Motivated by the fact that investors have limited ability to process information, I model investors’ bounded rational behavior in processing information and investigate its implications for asset pricing. Investors can make mistakes in processing information and thus have inaccurate estimates of fundamentals. This process generates “bounded rational risk.” I find that the volatility of stock and bond return increases in the presence of bounded rational investors, which can help explain the excessive volatility puzzle. The stock-bond return correlation becomes time varying and even negative and rational investors benefit from the trading with bounded rational investors.

Incentive Contracting Under Ambiguity Aversion

This paper studies a principal-agent model in which the information on future firm performance is ambiguous and the agent is averse to ambiguity. We show that if firm risk is ambiguous, while stocks always induce the agent to perceive a high risk, options can induce him to perceive a low risk. As a result, options can be less costly in incentivizing the agent than stocks in the presence of ambiguity. In addition, we show that providing the agent with more incentives would induce the agent to perceive a higher risk, and there is a discontinuous jump in the compensation cost as incentives increase, which makes the principal reluctant to reset contracts frequently when underlying fundamentals change. Thus, compensation contracts exhibit an inertia property. Lastly, the model sheds some light on the use of relative performance evaluation, and provides a rationale for the puzzle of pay-for-luck in the presence of ambiguity.

Incentive Contracting under Ambiguity-Aversion

This paper studies a principal-agent model in which the information on future firm performance is ambiguous and the agent is averse to ambiguity. We show that if firm risk is ambiguous, while stocks always induce the agent to perceive a high risk, options can induce him to perceive a low risk. As a result, options can be less costly in incentivizing the agent than stocks in the presence of ambiguity. In addition, we show that providing the agent with more incentives would induce the agent to perceive a higher risk, and there is a discontinuous jump in the compensation cost as incentives increase, which makes the principal reluctant to reset contracts frequently when underlying fundamentals change. Thus, compensation contracts exhibit an inertia property. Lastly, the model sheds some light on the use of relative performance evaluation, and provides a rationale for the puzzle of pay-for-luck in the presence of ambiguity.

Heterogeneous Preferences, Investment and Asset Pricing

We present a production-based general equilibrium model in which agents have heterogeneous risk aversion and heterogeneous discount rates. We find that agents wealth share, investment and Tobins q, and equity premium exhibit cyclical patterns. In particular, when agents have heterogeneous discount rates, both Tobins q and investment ratio are countercyclical. When agents have heterogeneous risk aversion, both Tobins q and investment exhibit procyclical patterns when the lower risk-averse agents wealth share is high, while they exhibit countercyclical patterns when the higher risk-averse agents wealth share is high.

Asymmetric information, illiquidity and asset returns: evidence from China

It is widely recognized that market risk cannot solely explain the cross-sectional asset returns. Since the seminal work of Fama and French (1992), an extensive amount of literature has introduced various factors to explain cross-sectional stock returns—e.g. liquidity, asymmetric information and momentum. For instance, Diamond (1985) shows that increased information disclosure reduces private information searching and the precision of private information. Easley and O’Hara (2004) argue that investors demand a premium in holding stocks with less public information, because uninformed investors experience an informational disadvantage compared to informed investors who are in a better position to adjust their portfolio to incorporate new information. Amihud and Mendelson (1986) suggest that investors require a higher return for holding illiquid stocks measured by the bid-ask spread. Despite the fact that prior literature has highlighted that asymmetric information and illiquidity could significantly influence asset pricing, empirical evidence does not demonstrate a consensus in regard to which factor is more important. Amihud and Mendelson (1989) and Eleswarapu (1997) find that liquidity is priced in the stock market. In contrast, Easley et al. (2002) show that private information measured by the probability of informed trading (PIN), dominates other determinants in explaining the variations in stock returns. In this paper, we investigate the effect of asymmetric information and illiquidity on cross-sectional stock returns in the Chinese market. China has a very short history in the