Lorenzo Bretscher
London Business School
Regent's Park, Sussex Place
London, NW1 4SA
United Kingdom

Phone: +44 (0)20 7000 8276

Published & Forthcoming Papers

with Christian Julliard and Carlo Rosa
Journal of International Economics, 77(1), March 2016, 78-96

We study the implications of human capital hedging for international portfolio choice. First, we document that, at the household level, the degree of home country bias in equity holdings is increasing in the labor income to financial wealth ratio. Second, we show that a heterogeneous agent model in which households face short selling constraints and labor income risk, calibrated to match both micro and macro labor income and asset returns data, can both rationalize this finding and generate a large aggregate home country bias in portfolio holdings. Third, we find that the empirical evidence supporting the belief that the human capital hedging motive should skew domestic portfolios toward foreign assets, is driven by an econometric misspecification rejected by the data.

with Lukas Schmid and Andrea Vedolin
Review of Financial Studies, 31(8), August 2018, 3019-3060

We revisit the evidence on real effects of uncertainty shocks in the context of interest rate uncertainty, which can be hedged in the swap market. We document that adverse movements in interest rate uncertainty predict significant slowdowns in real activity, at the aggregate and at the firm-level. We develop a dynamic model of corporate investment and risk management to examine how firms cope with interest rate uncertainty and test it using a rich dataset on corporate swap usage. Our results suggest that interest rate uncertainty depresses financially constrained firms' investment in spite of hedging opportunities, as for these firms risk management through swaps is, effectively, risky.

with Alex Hsu and Andrea Tamoni
Forthcoming at Macroeconomic Dynamics

We highlight a state variable misspecification with one accepted method to implement stochastic volatility (SV) in DSGE models when transforming the nonlinear state-innovation dynamics to its linear representation. Although the technique is more efficient numerically, we show that it is not exact but only serves as an approximation when the magnitude of SV is small. Not accounting for this approximation error may induce substantial spurious volatility in macroeconomic series, which could lead to incorrect inference about the performance of the model. We also show that, by simply lagging and expanding the state vector, one can obtain the correct state-space specification. Finally, we validate our augmented implementation approach against an established alternative through numerical simulation.

Working Papers

with Aytek Malkhozov and Andrea Tamoni

We examine the role of expectation, or news, shocks for the measurement of macroeconomic risk and the natural rate of interest. To this end, we estimate a New-Keynesian dynamic stochastic general equilibrium model that allows us to infer agents’ expectations about future fundamentals at different horizons. Accounting for news shocks results in better-specified macroeconomic risk factors that have significant explanatory power for the cross-section of stock and long-term bond returns. Further, anticipated changes in future productivity growth induce sizable fluctuations in the natural rate of interest, which we show to have important implications for the conduct of monetary policy.

with Federico M. Bandi and Andrea Tamoni

Higher levels of long-run economic uncertainty are shown to predict larger risk premia as well as lower inflation rates, lower consumption growth and lower output growth over business cycle to “generational” horizons. When seen through an asset pricing lens, the relation between long-run uncertainty and future inflation rates is a necessary by-product of three conditions: the (near) orthogonality of long-run uncertainty with respect to the dividend-to-price ratio, the ability of long-run uncertainty to strongly predict future risk premia, and its inability to predict nominal cash flows and real interest rates. A general class of equilibrium models with price rigidities is used to provide an economic channel.

Winner of the Nasdaq/EFA Doctoral Tutorial Best Paper Award, EFA 44th Annual Meeting Mannheim

Winner of the Unicredit & Universities Foundation Best Paper Award, Young Economists Conference Belgrade

Industries differ in the extent to which they can offshore their production. I document that industries with low offshoring potential have 7.31% higher stock returns per year compared to industries with high offshoring potential, suggesting that the possibility to offshore affects industry risk. This risk premium is concentrated in manufacturing industries that are exposed to foreign import competition. Put differently, offshoring effectively serves as an insurance against import competition. A two-country general equilibrium dynamic trade model in which firms have the possibility to offshore rationalizes the return patterns uncovered in the data: Industries with low offshoring potential carry a risk premium which is increasing in foreign import penetration. Within the model, the offshoring channel is economically important and lowers industry risk up to one-third. I find that an increase in trade barriers is associated with a drop in asset prices of model firms. The model thus suggests that the loss in benefits from offshoring outweighs the benefits from lower import competition. Importantly, the model prediction that offshorability is negatively correlated with profit volatility is supported by the data.

with Alex Hsu and Andrea Tamoni

Fiscal policy matters for bond risk premia. Empirically, government spending level predicts future excess bond returns while controlling for principal components and known predictors. Government spending level and volatility both forecast term structure level and slope movements. Theoretically, level shocks raise inflation (term structure level effect) when marginal utility is high, making nominal bonds a poor consumption hedge, thus generating positive inflation risk premia. Volatility shocks to spending have a strong yield curve slope (steepening) effect, producing positive term premia. Asset pricing tests using simulated data corroborate our empirical evidence. Last, fiscal shocks are amplified at the zero lower bound.

with Alex Hsu and Andrea Tamoni

The degree of risk aversion (RA) determines the impact of second moment shocks in DSGE models featuring stochastic volatility. Ceteris paribus, a higher coefficient of risk aversion leads to an amplification of macroeconomic responses to uncertainty shocks in standard New Keynesian models. This effect is even larger when the model economy features habit-induced time-varying RA. Empirically, and consistent with model predictions, we show that RA exacerbates the impact of uncertainty shocks. In particular, heightened level of RA during the 2008 crisis amplified the drop in output and investment by 21% and 16%, respectively, at the recession trough.

This paper examines limits to arbitrage and mispricing in Treasury protected securities (TIPS). To this end, I construct two different measures of disparity in bond prices from the smooth yield curve. I find that deviations in prices are highly correlated for different maturities and also between nominal Treasury bonds and TIPS. This suggests that arbitrage capital is efficiently allocated across markets and also along the yield curve. I then study the relative mispricing of nominal bonds and TIPS. While flight-to-liquidity explains well the mispricing for nominal bonds it does not for TIPS. In fact, TIPS mispricing is driven by short-term Treasury bond liquidity and the slope of the term structure of expected inflation. Moreover, TIPS mispricing predicts short-term excess returns of TIPS during the crises. This findings can be rationalized with investors who opt for more liquid nominal bonds whenever the short-term expected inflation is very low, i.e. short-term nominal bonds and short-term TIPS are close to perfect substitutes.