"Arbitrage Pricing under Ambiguity"
Revise and Resubmit at the Journal of Economic Theory
Abstract. This paper studies the implications of arbitrage in a large asset market under conditions of Knightian uncertainty. First, the notion of arbitrage provided by the existing literature is adapted to a market in which the assets’ returns are characterized by uncertainty across probability distributions. The setting delivers a mean-variance-ambiguity efficient frontier that is the analouge under uncertainty of the classical mean-variance frontier obtained under conditions of risk. In particular, the existence of a tradeoff between risk and ambiguity is demonstrated. Then, by assuming that the random returns are generated by a linear factor model, I show that the random expected returns can be approximated by linear combinations of the risk free rate and the systematic risk premia augmented by the systematic ambiguity premia and an idiosyncratic component. The presence of the latter is justified by the incomplete diversifiability of ambiguity through combinations of the assets in a portfolio, and is consistent with the existing tradeoff between risk and ambiguity. The sufficient conditions that let the approximation degenerate to the traditional Ross’ arbitrage pricing theory are then provided.
"Responsible Investing under Climate Change Uncertainty " with Monica Billio and Massimo Guidolin
Abstract. We propose a theory of responsible investing under conditions of ambiguity induced by climate uncertainty. We take steps from studying the portfolio allocation problem solved by a smoothly ambiguity averse representative agent. This new theory delivers three new insights. First, within this setting, we find that the returns ambiguity degree is a strictly increasing function of the environmental pollution scores of the assets in the menu of choice. Second, ambiguity-averse investors behave as environmentally motivated agents who allocate their wealth according to a mean-variance-ambiguity efficient frontier as well as their attitude towards risk and ambiguity. Third, the agents rationally choose "green" portfolios in order to reduce their exposition towards ambiguity and maximize their ambiguity-adjusted Sharpe ratio. Our theoretical predictions are consistent with the empirical literature on the realized rewards-to-risks trade-off of responsible investment.
"Pricing Climate Change Ambiguity" with Monica Billio, Yud Izhakian and Massimo Guidolin
Abstract. The recent theoretical literature on climate finance strongly asserts the existence of a close relationship between climate change and uncertainty about the probabilistic models (ambiguity) behind consumption and climate-related damages to it. While the transmission of Knighting uncertainty from climate change to the economy is a joint agreement among theorists, there is a lack of empirical evidence about the concrete relevancy of this phenomenon, especially regarding asset prices. This paper employs a standard consumption-based asset pricing framework to introduce and empirically test the relationship between climate change uncertainty and ambiguity in asset returns. The investigation performed on the U.S. stock market delivers insights that confirm what has been conjectured in the theoretical literature. Looking at the S\&P 500 index, 25\% of the total variation in the ambiguity degree is shown to be due to climate change. Furthermore, the analysis of the cross-section of the U.S. stock returns shows that the asset markets are already beginning to account for this additional source of uncertainty in evaluating the traded assets. The results are robust to any alternative methodology and sample employed.
"Responsible Preferences" - Draft available upon request
Abstract. This paper provides the axiomatization and studies the properties of a class of preferences employed in recent financial economics studies in which preferences under risk are combined with preferences for sustainability. The axiomatization of responsible preferences requires the generalization of the Weak Order, Continuity, and Weak Monotonicity axioms. Moreover, two further new axioms are necessary. Responsibility states that, for each lottery, the decision-maker always prefers the alternative that pairs the lottery with a higher ESG score. Consistency with EUT instead assumes that the decision-maker follows expected utility in choosing alternatives with the same ESG score. Unless particular assumptions are made, responsible preferences violate first-order stochastic dominance and do not allow for a classification of the decision-maker as a risk-averse, seeker, or neutral. This suggests that this kind of preference should be employed carefully.
"Arbitrage Pricing Theory for Bonds" with Mingyang Liu and Paolo Zaffaroni - Coming Soon
"CEO Overcaution and Capital Structure Choices " with Andrea Gheno and Chris Brooks, Financial Review, Forthcoming
Abstract. This paper develops a new version of the trade-off theory of corporate capital structure choices which accounts for biased managerial beliefs. Different from previous studies in the field, we characterize the bias as a distortion applied to the rate of return on equity. The resulting representation provides new insights about the effect of overconfidence and cautiousness on capital structure choices and on the rate of reversion towards a firm’s optimal level of leverage. In particular, the model predicts that overconfident (cautious) CEOs choose higher (lower) levels of debt and adjust towards the optimal debt-equity mix more slowly with respect to a rational CEO. Furthermore, we predict that if the degree of CEO cautiousness is sufficiently high, (s)he will opt for a zero leverage policy. Our empirical analysis produces evidence in support of these hypotheses as well as a possible theoretical justification in terms of CEO overcautiousness for the so far unexplained high number of very profitable zero levered firms.
"Explaining Abnormal Returns in Stock Markets: An Alpha-Neutral version of the CAPM" with Andrea Gheno and Chris Brooks, International Review of Financial Analysis, , 82, 2022
Abstract. This paper develops a behavioural asset pricing model in which traders are not fully rational as is commonly assumed in the literature. The model derived is underpinned by the notion that agents’ preferences are affected by their degree of optimism or pessimism regarding future market states. It is characterized by a representation consistent with the Capital Asset Pricing Model, augmented by a behavioural bias that yields a simple and intuitive economic explanation of the abnormal returns typically left unexplained by benchmark models. The results we provide show how the factor introduced is able to absorb the “abnormal” returns that are not captured by the traditional CAPM, thereby reducing the pricing errors in the asset pricing model to statistical insignificance.
"Optimism, Volatility and decision-making in Stock Markets" with Andrea Gheno and Chris Brooks, International Review of Financial Analysis, , 66, 2019
Abstract. In this paper we introduce a new, analytically tractable framework for decision-making under risk in which psychological characteristics related to the degree of optimism or pessimism of the decision-maker are considered. The framework we propose, which is based on a two-parameter optimism weighting function, is applicable to a wide range of decision-making models and renders even the simplest, such as expected utility theory, able to describe the behavior of decision-makers within a more parsimonious framework. In particular, the optimism weighting function that we introduce is formalized as a function of the volatility of the lotteries faced. This simplifies applications of the framework to financial decision-making problems. For the purpose of demonstrating this applicability, we also derive an extension to a well-known asset pricing model to elicit a measure of market sentiment in the U.S. stock market. The results lend support to the relevance of the degree of optimism, both in financial decision-making problems and in the expectations that agents have of excess returns in the market.