Valery Polkovnichenko

Human Capital and the Private Equity Premium

When capital market is imperfect, an entrepreneur has to invest substantial personal funds to start a firm and has to bear large firm-specific risk. Furthermore, if a typical entrepreneur is risk averse, private equity should earn a premium for idiosyncratic risk. In this paper I explore the interaction of human capital with the decision to become an entrepreneur. I calibrate a model of entrepreneurial choice to illustrate a significant attenuating effect of human capital on the premium for firm-specific risk. When an entrepreneur can quit the business and work for hire, the firm-specific risk premium is order of magnitude lower than without this option. While an entrepreneur puts at risk a substantial fraction of financial wealth, she does not commit all human capital to the current business. At stake is only the labor income forgone while managing the firm and the rest of human capital is unaffected by the business risk. Empirical evidence suggests that private equity does not earn any significant premium over publicly traded equity. The model with human capital is consistent with this observation, assuming typical entrepreneur forgoes a small expected return (1.5%) in lieu of intangible benefits of entrepreneurship. (Copyright: Elsevier)

Quantifying the Distortionary Fiscal Cost of ‘The Bailout’

We utilize an overlapping generations model with endogenous production and incomplete markets to quantify the distortionary costs associated with financing the increase in government expenditures directed to investments in the private sector in 2008 and 2009 (also known as ‘the bailout’), and its differential impact on different groups of the population (in the USA). In our baseline calibration, this distortion corresponds to a loss of approximately

Downside Consumption Risk and Expected Returns

300 billion dollars in total household consumption. For plausible alternative assumptions regarding both the expected and actual duration of this increase in expenditures, or the willingness of foreign institutions and/or investors in absorbing additional government debt, this number can increase to

Dynamics of Firm Savings and Investment with Temporary and Persistent Shocks

800 billion. We find that the cost falls more dramatically on those households which are either older and/or wealthier. Retirees face approximately 50% of the cost, as younger agents still expect to be alive when the economy has returned to its steady-state. Across wealth groups, the top 25% of the wealth distribution bears almost two thirds of the cost.

Ambiguity Aversion and the Arbitrage Pricing Theory

The expected utility model captures the attitude toward risk exclusively through the marginal utility. Recognizing this limitation several models explicitly account for aversion to downside risk. This paper presents non-experimental evidence that this feature is empirically relevant in asset pricing.I use rank-dependent expected utility to model aversion to downside risk and derive Euler equations for consumption and asset returns. The resulting model nests the standard CCAPM and allows estimation of preferences parameters by GMM and the tests of significance of the downside risk aversion. I estimate the model using Fama and French 25 portfolios and find that it performs considerably better than the standard CCAPM. The parameter estimates imply that the left tail outcomes are over-weighted while the right tail outcomes are under-weighted. Asset prices reflect a sizable premium for downside risk and the corresponding parameter is strongly significant. The downside risk premium exhibits significant variation across the test portfolios and contributes to value and size premia.

Probability Weighting Functions Implied in Options Prices

We model the savings and investment decisions of firms facing costly external financing and a mix of temporary and persistent shocks to their cash flows. We show that, while exposure to both types of shocks induces firms to save, the two types of shocks generate distinct and typically opposite effects on the dynamics of savings and investment. We develop several novel predictions about the effect of the mix of temporary and persistent shocks on the level of cash savings, the sensitivity of savings to cash flows and the sensitivity of investment to cash savings. Our empirical tests support these predictions and demonstrate the importance of accounting for the mix of persistent and temporary shocks to firm cash flows when explaining cross-sectional variation in corporate savings and investment.

Optimal Savings with Taxable and Tax-Deferred Accounts

We consider a linear factor APT model and assume that agents are ambiguity averse with respect to payoffs of arbitrage portfolios. In contrast to the standard result, pricing errors need not converge to zero in the limit as the number of assets goes to infinity. Even in the case of exact factor structure, pricing errors may be nonzero and would not be eliminated by ambiguity averse arbitragers. This is because ambiguity about factor loadings and/or expected returns remains even in pure factor portfolios. Moreover, when there is ambiguity about factor sensitivities, strict arbitrage is impossible and pricing errors need not be bounded at all. Replacing a strict no-arbitrage requirement with one which imposes bounds on mean-standard deviation ratios for portfolio returns implies a bound on the pricing error which depends on the maximum admissible mean-standard deviation ratio, ambiguity about the coefficients in the return generating process (RGP), and factor volatilities. We also consider a case when agents can learn the RGP from the data using the framework of Epstein and Schneider (2007, REStud.). We show that pricing errors induced by ambiguity about RGP are quantitatively significant after accounting for the effects of learning. The results have empirical implications for tests of APT, market efficiency (anomalies) and pricing of idiosyncratic risk.