Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

G11: Portfolio Choice; Investment Decisions

Sharing R&D Risk in Healthcare via FDA Hedges

Adam Jørring, Andrew W. Lo, Tomas Philipson, Manita Singh, Richard Thakor

The high cost of capital for firms conducting medical research and development (R&D) has been partly attributed to the government risk facing investors in medical innovation. This risk slows down medical innovation because investors must be compensated for it. We propose new and simple financial instruments, Food and Drug Administration (FDA) hedges, to allow medical R&D investors to better share the pipeline risk associated with FDA approval with broader capital markets.

Socioeconomic Status and Learning from Financial Information

Camelia Kuhnen, Andrei Mui

The majority of lower socioeconomic status (SES) households in the U.S. and Europe do not have any stock investments, which is detrimental to wealth accumulation. Here, we examine one explanation for this puzzling fact, namely, that economic adversity may influence how people learn from financial information. Using experimental and survey data from the U.S. and Romania, we find that lower SES individuals form more pessimistic beliefs about the distribution of stock returns and are less likely to invest in stocks.

Climate Change And Long-Run Discount Rates: Evidence From Real Estate

Stefano Giglio, Matteo Maggiori, Johannes Stroebel, Andreas Weber

The optimal investment to mitigate climate change crucially depends on the discount rate used to evaluate the investment’s uncertain future benefits. The appropriate discount rate is a function of the horizon over which these benefits accrue and the riskiness of the investment. In this paper, we estimate the term structure of discount rates for an important risky asset class, real estate, up to the very long horizons relevant for investments in climate change abatement. We show that this term structure is steeply downward-sloping, reaching 2.6% at horizons beyond 100 years.

Measuring potential market risk

Mikael Bask

We argue herein that there is a fundamental and an important difference between the market risk and the potential market risk in financial markets. We also argue that the spectrum of smooth Lyapunov exponents can be used in (λ,σ2)-analysis, which is a method to measure and monitor these risks. The reason is that these exponents focus on the stability properties (λ) of the stochastic dynamic system generating asset returns, while more traditional risk measures such as value-at-risk are concerned with the distribution of asset returns (σ2).

International Liquidity and Exchange Rate Dynamics

Xavier Gabaix, Matteo Maggiori

We provide a theory of the determination of exchange rates based on capital flows in im- perfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for finan- cial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus impacting both the level and volatility of ex- change rates.

Capital Asset Pricing under Ambiguity

Yehuda Izhakian

This paper generalizes the standard mean–variance paradigm to a mean–variance–ambiguity paradigm by relaxing the assumption that probabilities are known and instead assuming that probabilities are themselves random. It extends the CAPM from risk to uncertainty by incorporating ambiguity. This model makes the distinction between systematic ambiguity and idiosyncratic ambiguity and proves that the ambiguity premium is proportional to systematic ambiguity. It introduces a new measure of uncertainty that combines risk and ambiguity.

Information Inertia

Philipp Illeditsch, Scott Condie, Jayant Ganguli

We study how information about an asset affects optimal portfolios and equilibrium asset prices when investors are not sure about the model that predicts future asset values and thus treat the information as ambiguous. We show that this ambiguity leads to optimal portfolios that are insensitive to news even though there are no information processing costs or other market frictions. In equilibrium, we show that stock prices may not react to public information that is worse than expected and this mispricing of bad news leads to profitable trading strategies based on public information.

Market Expectations in the Cross Section of Present Values

Bryan Kelly, Seth Pruitt

Returns and cash flow growth for the aggregate U.S. stock market are highly and robustly predictable. Using a single factor extracted from the cross section of book- to-market ratios, we find an out-of-sample return forecasting R-squared as high as 13% at the annual frequency (0.9% monthly). We document similar out-of-sample predictability for returns on value, size, momentum and industry-sorted portfolios. We present a model linking aggregate market expectations to disaggregated valuation ratios in a dynamic latent factor system.

Speculation and Risk Sharing with New Financial Assets

Alp Simsek

While the traditional view of financial innovation emphasizes the risk sharing role of new financial assets, belief disagreements about these assets naturally lead to speculation, which represents a powerful economic force in the opposite direction. This paper investigates the effect of financial innovation on portfolio risks in an economy when both the risk sharing and the speculation forces are present. Financial assets provide hedging services but they are also subject to speculation because traders do not necessarily agree about their payoffs.