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Broad Theme of

Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Conditional Correlations of Macro


Variables and Implications for Asset
Prices
Apoorva Javadekar1
Joint With

Rui Albuquerque2

March 10, 2013

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Broad Questions
1

Understanding the structure of the Cross Country


Correlation for Macro Variables:
Do macro variables across countries co move more strongly
during certain times than other?
More precisely: Do cross country correlations are conditionally
asymmetric?

Asset Pricing and Risk Sharing Implications


How does regime switching or jumps in fundamental macro
variables affect asset prices?
In particular: Does asymmetric correlations in output translate
in to asymmetric correlations for stock returns?
What are the implications for Risk Sharing arrangements?

Can current macro models explain these type of


conditional asymmetries in Macro Variables?
Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Basics: Exceedence
Correlation
1

Consider a joint stochastic processes: {Xt, Y t } with E (X t ) =


E (Y t ) = 0 and unit variance.

Exceedence Correlation at level c:


(X , Y ;
c)=

( X, Y |X > c, Y > c )
if
c 0
(X, (X,
Y |X <
Y c,
< Yc >
) c ) if=c
For normal distribution
Y |c,
X>
0 c ) for every c
(X, Y |X < c, Y <
Symmetric Exceedences

Albuquerque & Javadekar

Asymmetries In Macro

(1)

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Output Growth: Simple Statistics


Table :Evidence on Asymmetries in Output Correlations

Statistics

1980-2012

1980-1998

1999-2012

Mean Growth %
Mean Volatility %
Mean Upside Vol %
Mean Downside Vol %
Mean Correlation
Mean Positive Exceedence
Mean Negative Exceedence

1.008
15.77
9.03
12.20
0.23
0.08
0.31

1.65
14.89
9.39
9.89
0.14
0.102
0.105

.079
16.59
8.30
14.24
0.33
0.12
0.46

3
Source: Monthly Data from OECD Library for G7: Growth Rates are
annualized and data is measured at Monthly frequencies

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Output Co movement: Drop at Zero !


Figure :Exceedence Correlations - Against
OECD

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Asymmetries in Output Correlations: Drop at


Zero !
Figure :Exceedence Correlations - Against Germany

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Asymmetries in Output Correlations: Drop at


Zero !
Figure :Exceedence Correlations - Against USA

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Some Robustness
Checks
1

2
3
4

Formal Hypothesis testing using Zhou, Tu and Hong Test of


asymmetry (2007)
Data filtering using growth and HP filter
Time Aggregation: Quarterly vs
Monthly
Conditioning on single country being a threshold instead of
both
Justification for Industrial Production as a proxy for
Output: (See Dumas et al. 2003)
GDP and IP highly correlated
IP data available at monthly frequency: Trade off between low
frequency movements vs having more observations for
conditioning
BehaviorAlbuquerque
in recessions
is similar
(exception in 2001)
& Javadekar
Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Consumption Risk Sharing: Quick


Exercise
1

Consider Brandt, Cochrane and Santa Clara Index of Risk


Sharing
RS t = 1

2(ln mtf+1 ln mtd+1 )


2(ln mtf+1 ) + 2(ln md )

Interpretation:

(2)

t +1

Numerator - volatility of the difference in consumption growth


rate = Risk component not shared
Denominator - Total volatility in consumption growth rates =
total risk that can be shared
Index = 1 - risk fraction not shared = fraction of risk shared
3

Idea: Compute Risk Sharing index conditional on Output


growth
Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

Consumption Risk Sharing: Upside vs


Downside
Figure :Cross Country Risk Sharing - Upside vs
Downside

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

((y, y), (c, c))

Figure :Output and Consumption Correlations -Downside

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Asymmetries in Output
Implications for Risk
Sharing

((y, y), (c, c))

Figure :Output and Consumption Correlations -Upside

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Stocks: Vanishing
Discontinuity at Zero!

Figure :Asymmetric Cross Country Correlations in Stock


Returns

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Summarizing Main
Evidence
1

Cross country output growth follows regimes; highly


correlated in downturns
Stock returns correlations becoming symmetric: No
major difference in correlations in upside vs downside
Risk Sharing is state dependent: High international
consumption risk sharing in downturns
Asset Returns do not inherit the output growth
distributional properties

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Properties of Pricing
Model
1

Two Facts

In EU area, discount rate shocks are highly correlated


Stock returns correlations in EU area are becoming symmetric,
while output growth correlation is becoming asymmetric.
2

We want a model where asset returns are driven by


discount rate shocks more than cash flow shocks.
Question: Can regime Switching correlation in output growth
generate time variation in discount rates?
First Steps: Take a regime switching process for output
growth where correlations are different in different regimes
and try to solve for optimal allocation.

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Framework
1

2
3

Recipe: Take output growth as a joint regime switching


process, solve for consumption allocations, estimate the
regime switching process and price the assets
Framework: Two countries H and F, single good
Output Growth Follows regime Switching
.

(6 y (s t ), 6 y (s t )) N (s t ), (s t )
4
5
6

(3)

Conjecture: Correlations higher in one regime that other.


Preferences in both countries are simple CRRA
Complete Markets consumption growth rates are
perfectly correlated

C ti +1 = Y t +1 + Yt +1
(4)
Y t + Yt
C ti

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

PD Ratios: General
Issues Involved
1

State Variables: Relative Share of domestic tree () and


regime both act as a state variables
Cecchetti, Lam and Mark (1990) Method: Conjecture
that PD ratio is constant within regime
CLM method can not work: PD ratio is a regime
dependent function of relative share. Essentially we need to
find two functions.
Note: Distribution of Output growth and relative share
growth depends upon current regime

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Literature Review

3
4

Models of Regime Switching: Hamilton (1989), Cecchetti,


Lam and Mark (1990, 1993)
Asset Pricing: Cochrane and Longstaff, Santa-Clara (2008),
Dumas, Harvey and Ruiz (2003)
Risk Sharing: Backus and Smith (1993)
Asymmetries: Longin and Solnik (2001), Ang and Chen
(2002), Ang (2011), Brandt, Cochrane, Santa Clara
(2006)

Albuquerque & Javadekar

Asymmetries In Macro

Broad Theme of
Research Empirical
Evidence Links to
Asset Prices
Asset Pricing Implications
Literature Review

Thank You for


Coming !

Albuquerque & Javadekar

Asymmetries In Macro

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