The “.DotCom” crisis of 2001, and the crisis of the “subprime mortgages” of 2008, are just two events that show the impact that financial events have on the real economy. This motivates the research to understand the mechanisms that connect the fluctuations in the price of financial assets with the aggregate macroeconomic variables, such as consumption, investment, employment, and production level. To better understand the transmission mechanism of these events, it is necessary to understand the role of financial markets.
Faced with the existence of uncertainty over time, agents present different needs. For example: Financing a project today, but with no enough money to fund it; needing to pay the rent of an apartment, but not being able to do so until getting the end-of-month paycheck; the need to lock the future price of raw materials to reduce the risk in the balance sheet of the business; among others. Thus, one can argue that the main role of financial markets is to provide economic agents with different instruments (assets) to help them desynchronize intertemporal risks.
For the valuation of these assets, economists have developed different theoretical models to understand prices formation. One of these models was proposed by Kenneth Arrow and Gerard Debreu in 1954, and although it is more of a mathematical exercise – since the assumptions used do not allow real data to be reflected – it is a basic model of a highly efficient and frictionless financial system. Under these conditions, the price of assets is determined by the equilibrium between its supply and demand through all the contingent states of nature.
As a result of this equilibrium, the asset’s price will be the present value of the future cash flow (dividends) that it generates. The previous idea is reflected in the Gordon equation, which is commonly used to determine equity prices. This equation implies that an asset with a perpetual flow of dividends can be expressed as a division between the current dividend and the difference between the discount rate and its nominal growth rate. Due to this, the asset price determination depends on the correct “discount factor”, “usually presented as the sum between the risk-free rate and the market risk premium.
The risk-free rate can be safely approximated by using, the interest rate offered by the treasury bonds. Nevertheless, the market risk premium depends on the particular behavior of the cash flow of each asset, so it usually uses asset pricing models to determine it. Perhaps the most widely used model is the CAPM (Capital Asset Pricing Model), where the risk premium is determined by the degree to which the risk of the asset is not diversifiable concerning all other assets in the market, and where the model represents it by the beta factor and the excess of the market return over the risk-free rate.
The CAPM, being a partial equilibrium model, only considers the behavior of the financial variables. Another alternative is the general equilibrium models such as the CCAPM (Consumption-Based Capital Asset Pricing Model), this type of model considers preferences, technology, and other real factors to determine the discount factor; however, they tend to be very stylized as they do not consider financial frictions or transaction costs. Notwithstanding it, this type of model shows a clear link between the price of assets and aggregate variables such as consumption or investment. The allocation role of the asset prices in these models is related to the households, investors, and corporation’s decisions. Particularly, households change their current consumption by changes in asset prices, altering the substitution rate between their consumption allocations overtime.
The link between consumption and the price of assets also depends on the type of asset. According to Mishkin (2007), the price of houses has a lesser impact than equity prices because of its disconnection to increases in productive potential. Nonetheless, house prices are less volatile than equity prices, implying that changes in house prices are likely to be perceived as more permanent than changes in equity prices. A change in house prices has a large impact on consumption. Carroll et al. (2011) suggest that the propensity to consume of USD 1.00 increase in housing wealth ranges between two (short-run) to nine (long-run), it’s twice as large as estimated for equity wealth.
Also, the correlation between asset prices and current and future values of activity shows that equity prices are better leading indicators of investment than GDP (Growth Domestic Product) or consumption (Aylward and Glen, 2000). Although this depends on the country and its market-specific features, Claessens et al. (2009) show for a large number of countries for a period of almost 50 years, that in the first year of a typical recession, equity prices decline on a year to year basis by roughly 35%. Anticipating the recession, the equity prices registered positive growth before three-quarters of decline.
Moreover, the discussion of the macro finance linkage has to take into account the international dimension. For instance, recent models for small open economies aim at examining this relationship. Adler and Dumas (1983) extend the domestic CAPM to an international context, suggesting that asset prices are determined by the trade-off between exchange rates risk and the diversification benefits of global investment, however, these stills be a partial equilibrium model. Devereux and Sutherland (2009) extend the analysis to general equilibrium models in a dynamic context with incomplete markets. Still, it faces difficulty matching some basic statistical moments such as variance and persistence of asset prices, including exchange rates. These problems possibly occur by the cross-country correlations of equity prices which tend to have higher volatility than fundamentals. Also, financial integration can occur, which extends the scope of increments in the hedging behavior of investors, amplifying correlations beyond what fundamentals do. Finally, Engel (2014) suggests heterogeneity in agents and other asymmetries could cause the failures of the standard international asset pricing models.
The current challenge for economic models of asset pricing is on this topic, “Heterogenous Agents” which was the central theme of the RIEF Master Class that took place on August 16. You can find all the lecture notes here.
Notes based on:
[1] Claessens, S., & Kose, M. A. (2018). Frontiers of macrofinancial linkages. BIS Paper, (95).
[2] Mishkin, F. S., 2007, “Enterprise Risk Management and Mortgage Lending,” Speech at the Forecaster’s Club of New York, January 17.
[3] Carroll, C. D., M. Otsuka, and J. Slacalek, 2011, “How Large Are Housing and Financial Wealth Effects? A New Approach,” Journal of Money, Credit, and Banking, Vol. 43, No. 1, pp. 55–79.
[4] Carroll, C. D., M. Otsuka, and J. Slacalek, 2011, “How Large Are Housing and Financial Wealth Effects? A New Approach,” Journal of Money, Credit, and Banking, Vol. 43, No. 1, pp. 55–79.
[5] Claessens, S., M. A. Kose, and M. E. Terrones, 2009, “What Happens During Recessions, Crunches, and Busts?” Economic Policy, Vol. 60, pp. 653–700.
[6] Adler, M., and B. Dumas, 1983, “International Portfolio Choice and Corporation Finance: A Synthesis,” Journal of Finance, Vol. 38, No. 3, pp. 925–84.
[7] Devereux, M. B., and A. Sutherland, 2009, “A Portfolio Model of Capital Flows to Emerging Markets,” Journal of Development Economics, Vol. 89, No. 2, pp. 181–93.
[8] Engel, C., 2014, “Exchange Rates and Interest Parity,” in Handbook of International Economics, Vol. 4, G. Gopinath, E. Helpman, and K. Rogoff (eds), pp. 453–552. Amsterdam: North-Holland.
Álvaro.
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