Pietro Veronesi

Stock Valuation and Learning About Profitability

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market-to-book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firms lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Rational IPO Waves

We argue that the number of firms going public changes over time in response to time variation in market conditions. We develop a model of optimal IPO timing in which IPO waves are caused by declines in expected market return, increases in expected aggregate profitability, or increases in prior uncertainty about the average future profitability of IPOs. We test and find support for the models empirical predictions. For example, we find that IPO waves tend to be preceded by high market returns and followed by low market returns.

Information Acquisition in Financial Markets

Previous work on information and financial markets has focused on a special set of assumptions: agents have exponential utility, and random variables are normally distributed. These assumptions are often necessary to obtain closed-form solutions. We present an example with alternative assumptions, and demonstrate that some of the conclusions from previous literature fail to hold. In particular, we show that in our example, as more agents acquire information, prices do not necessarily become more informative, and agents may have greater incentive to acquire information. Learning can therefore be a strategic complement, allowing for the possibility of multiple equilibria.

What Ties Return Volatilities to Price Valuations and Fundamentals

Stock and Treasury bond comovement, volatilities, and their relations to their price valuations and fundamentals change stochastically over time, in both magnitude and direction. These stochastic changes are explained by a general equilibrium model in which agents learn about composite economic and inflation regimes. We estimate our model using both fundamentals and asset prices and find that inflation news signal either positive or negative future real economic growth depending on the times, thereby affecting the direction of stock-bond comovement. The learning dynamics generate strong nonlinearities between volatilities and price valuations. We find empirical support for numerous predictions of the model.

The Peso problem hypothesis and stock market returns

Abstract The Peso problem hypothesis has often been advocated in the financial literature to explain the historically puzzlingly high risk premium of stock returns. Using a dynamic model of learning, this paper shows that the implications of the Peso problem hypothesis are much more far reaching than the ones commonly advocated, implying most of the stylized facts about stock returns. These include high risk premia, time-varying volatility, asymmetric volatility reaction to good and bad news, excess sensitivity of price reaction to dividend changes and thus excess return volatility.

The Price of Political Uncertainty: Theory and Evidence from the Option Market: The Price of Political Uncertainty

We empirically analyze the pricing of political uncertainty, guided by a theoretical model of government policy choice. To isolate political uncertainty, we exploit its variation around national elections and global summits. We find that political uncertainty is priced in the equity option market as predicted by theory. Options whose lives span political events tend to be more expensive. Such options provide valuable protection against the price, variance, and tail risks associated with political events. This protection is more valuable in a weaker economy and amid higher political uncertainty. The effects of political uncertainty spill over across countries.

Belief-dependent Utilities, Aversion to State-Uncertainty and Asset Prices

This Paper reinterprets standard axioms in choice theory to introduce the concepts of ‘belief dependent’ utility functions and aversion to ‘state-uncertainty’. It shows that this type of preference helps to explain the various stylized facts of asset returns, including a high equity risk premium, a low risk-free rate, a high return volatility, stock return predictability and volatility clustering. In one particular specification consistent with habit formation preferences, I also argue that ‘aversion to state-uncertainty’ gives rise to ‘aversion to long-run risk’, that is, to the uncertainty surrounding the long-run average of future consumption. In order to solve for asset prices and returns under general conditions about the hidden state variable, the Paper also develops a discretization methodology to obtain approximate analytical solutions. In a parsimonious parametrization, I then show that the model calibrated to real consumption generates unconditional moments for asset returns that closely match the empirical ones. Finally, due to the estimated time-variation in the dispersion of the conditional distribution on the drift rate of consumption, the model also generates a time series of conditional return volatility in line with the ex-post integrated volatility of stock returns.

Short and Long Horizon Term and Inflation Risk Premia in the US Term Structure: Evidence from an Integrated Model for Nominal and Real Bond Prices under Regime Shifts

We provide an integrated utility-based model for nominal and index-linked bonds for the case where the CPI and real consumption follow a joint lognormal - regime shift model. Working both in continuous and in discrete time, we discuss a systematic bias in the computation of term and inflation risk premia. We fit the model to the time series of fundamentals and short and long yields to find (i) a low coefficient of risk aversion, (ii) term premia that switch sign over time at both the short and long horizon, (iii) always positive inflation risk premia, although very low in recent times, (iv) quite variable real rates both at the short horizon and at the long horizon.

Option-Based Credit Spreads

We present a novel empirical benchmark for analyzing credit risk using “pseudo firms�? that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, pseudo bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors’ over-estimation of default risks, and corporate frictions do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.

Income Inequality and Asset Prices Under Redistributive Taxation

We develop a simple general equilibrium model with heterogeneous agents, incomplete financial markets, and redistributive taxation. Agents differ in both skill and risk aversion. In equilibrium, agents become entrepreneurs if their skill is sufficiently high or risk aversion sufficiently low. Under heavier taxation, entrepreneurs are more skilled and less risk-averse, on average. Through these selection effects, the tax rate is positively related to aggregate productivity and negatively related to the expected stock market return. Both income inequality and the level of stock prices initially increase but eventually decrease with the tax rate. Investment risk, stock market participation, and skill heterogeneity all contribute to inequality. Cross-country empirical evidence largely supports the models predictions.