Philipp Karl
ILLEDITSCH
Published or Forthcoming Papers
Information Inertia (joint with Jayant Vivek Ganguli and Scott Condie). Journal of Finance, 2021, 76 (1), 443-479. (SSRN version and Online Appendix)
Abstract. We show that aversion to risk and ambiguity leads to information inertia when investors process public news about assets. Optimal portfolios do not always depend on news that is worse than expected; hence, the equilibrium stock price does not reflect this bad news. This informational inefficiency is more severe when there is more risk and ambiguity but disappears when investors are risk neutral or the news is about idiosyncratic risk. Information inertia leads to news momentum (e.g. after earnings announcements) and is consistent with low trading activity of households. An ambiguity premium helps explain the macro and earnings announcement premium.
Residual Inflation Risk. Management Science, 2018 64 (11), 5289-5314. (SSRN version)
Abstract. I decompose inflation risk into (i) a component that is correlated with factors that determine investors’ preferences and investment opportunities and real returns on real assets with risky cash flows (stocks, corporate bonds, real estate, commodities, etc.), and (ii) a residual inflation risk component. In equilibrium, only the first component earns a risk premium. Therefore, investors should avoid exposure to the residual component. All nominal bonds, including money-market accounts, have constant nominal cash flows, and thus their real returns are equally exposed to residual inflation risk. In contrast, inflation-protected bonds provide a means to avoid cash flow and residual inflation risk. Hence, every investor should put 100% of her wealth in real assets (inflation-protected bonds, stocks, corporate bonds, real estate, commodities, etc.) and finance every long/short position in nominal bonds with an equal amount of other nominal bonds or by borrowing/lending cash; that is, investors should hold a zero-investment portfolio of nominal bonds and cash.
Disagreement about Inflation and the Yield Curve (joint with Paul Ehling, Michael Gallmeyer, and Christian Heyerdahl-Larsen). Journal of Financial Economics, 2018, 127 (3), 459-484. This article was covered by Knowledge@Wharton. (SSRN version and Online Appendix)
Abstract. We show that inflation disagreement, not just expected inflation, has an impact on nominal interest rates. In contrast to expected inflation, which mainly affects the wedge between real and nominal yields, inflation disagreement affects nominal yields predominantly through its impact on the real side of the economy. We show theoretically and empirically that inflation disagreement raises real and nominal yields and their volatilities. Inflation disagreement is positively related to consumers’ cross-sectional consumption growth volatility and trading in fixed income securities. Calibrating our model to disagreement, inflation, and yields reproduces the economically significant impact of inflation disagreement on yield curves.
Risk Premia and Volatilities in a Nonlinear Term Structure Model (joint with Peter Feldhuetter and Christian Heyerdahl-Larsen). Review of Finance, 2018, 22 (1), 337-380. This article was covered by Knowledge@Wharton. (SSRN version)
Abstract. We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of US Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with Unspanned Risk Premia (URP) and Unspanned Stochastic Volatility (USV).
Ambiguous Information, Portfolio Inertia, and Excess Volatility. Journal of Finance, 2011, 66 (6), 2213-2247. (SSRN version and Online Appendix)
Abstract. I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, investors may not react to price changes even if there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility.
Working Papers
Demand Disagreement (joint with Christian Heyerdahl-Larsen, revise and resubmit at the Journal of Financial Economics). March 2023.
Abstract. We show that disagreement about future yields cannot be explained by disagreement about fundamental macroeconomic variables. This disconnect is inconsistent with models with differences in beliefs as equilibrium imposes a tight connection between asset return disagreement and fundamental disagreement, leading to a “disagreement correlation” puzzle. We propose a model of disagreement about future asset demand – demand disagreement - and show that the model can rationalize the low correlation between asset returns and fundamentals and return disagreement driven by disagreement about future discount rates independent of macroeconomic fundamentals, while at the same time being consistent with several asset pricing facts.
Economic Growth through Diversity in Beliefs (joint with Christian Heyerdahl-Larsen and Howard Kung). July 2023.
Abstract. We study a macro-finance model with entrepreneurs who have diverse views about the likelihood that their ideas will lead to successful innovations. These views and the resulting experimentation stimulate economic growth and overcome market failures that would otherwise occur in an equilibrium without this diversity. The resulting benefits for future generations come at the cost of higher wealth and consumption inequality because a few entrepreneurs will ex-post be successful while most entrepreneurs will fail. Hence, our model provides a potential explanation for the “entrepreneurial puzzle” in which entrepreneurs choose to innovate despite taking on substantial idiosyncratic risk accompanied by low expected returns. Venture capital funds and taxes enhance risk sharing among entrepreneurs, stimulating innovation and growth unless high taxes deplete entrepreneurial capital. Redistribution via taxes reduces inequality and can raise interest rates. Nevertheless, a tradeoff exists between risk-sharing and the exertion of costly effort, giving rise to a hump-shaped economic growth curve when plotted against tax rates.
Model Selection by Market Selection (joint with Christian Heyerdahl-Larsen and Johan Walden). November 2022.
Abstract. We define the concept of market beliefs in an economy with disagreement, such that equilibrium in a representative agent economy with market beliefs is equivalent to equilibrium in the disagree- ment economy. In general, the mapping from individual agent beliefs to market beliefs is complex and nonlinear, suggesting that several puzzles that arise in the representative agent setting may in fact be due to disagreement, and limiting the possibility of drawing inferences about the pricing kernel and beliefs from asset prices alone. Nevertheless, market beliefs are often highly informative about objective probabilities. We analyze the properties of the market belief process, viewed as an estimator, and show that it satisfies several remarkable properties, nesting Bayesian updating, frequentist estimators, and allowing for shrinkage estimation. We relate these properties to the literature on market selection and to the adaptive market hypothesis.Asset Pricing with the Awareness of New Priced Risks (joint with Christian Heyerdahl-Larsen and Petra Sinagl). November 2022.
Abstract. Recessions lead to substantial, yet not immediate drop in output. The low and often negative growth during recessions is typically followed by a steady recovery with abnormally high growth. We propose a theory where a recession is preceded by the introduction of a new risk source. The expected impact on economic growth of this new risk is negative and varies in terms of duration and severity. Consistent with the data, recovery is slow but characterized by higher than average output growth. We show that the expected path of both risk premia and return volatilities are hump-shaped at the start of a recession, that is, risk premia and return volatilities do not immediately rise which is in contrast to most asset-pricing models. We calibrate the model to the average economic recession and recovery and show that it quantitatively matches the unconditional asset pricing moments as well as asset pricing moments during recessions.Distorted Risk Incentives from Size Threshold-Based Regulations (joint with Burton Hollifield, Shane Johnson, and Yan Liu). April 2022.
Abstract. Many regulations are based on size thresholds. We develop a model that shows that such regulations distort risk-taking incentives, providing above-threshold firms with greater incentives to take risk and below-threshold firms the opposite. Risk distortion varies nonlinearly as a function of the distance from the size threshold, and is increasing in the magnitude of the regulatory costs. We test our model by examining changes in risk around the Dodd-Frank Act, a major regulation with size thresholds. We provide empirical evidence that is consistent with the main predictions of the model.The Market View (joint with Christian Heyerdahl-Larsen). January 2021.
Abstract. When investors disagree and trade on their views about asset returns, market prices reflect the wealth/consumption share weighted average belief about risk premia, where more accurate, risk tolerant, or patient investors carry a larger weight. We explore the properties of this market view, and show that many puzzling properties of survey measures can be reconciled within disagreement models. For instance, a model with disagreement about output growth matches the negative correlation between statistical and survey-based measures of the risk premium, the higher variance and lower persistence of statistical measures of the risk premium and the appearance of return extrapolation.
The Effects of Speculation on Constrained Households (joint with Christian Heyerdahl-Larsen and Petra Sinagl). (Draft will be posted soon)
We study how financial speculation affects households who do not participate in financial markets. We show that the consumption/wealth shares of households decrease because they forgo they equity premium and pay the liquidity premium for cash (a negative inflation risk premium in our model) by putting all their savings in a short term bank account but not because investors are speculating. In an infinite horizon economy, non participation in financial markets would lead to consumption/wealth shares of households that go to zero whereas in our OLG model with finite life expectancy it only leads to a decrease in the households’ average consumption share and thus allows us to study the effects of financial speculation on non participating households. Interestingly, financial speculation in the stock market due to disagreement about expected output growth does not affect households’ average consumption share and even lowers its volatility. In contrast, disagreement about output growth increases the cross-sectional consumption volatility of speculators. Disagreement has no effect on average valuation ratios and lowers their volatility if speculators have the same time preferences. Otherwise valuations are on average lower and more volatile. Precautionary savings increase and thus interest rates decrease when household do not invest in the stock market. Disagreement raises the interest rate volatility and thus the consumption growth volatility of households but has no effect on its mean unless speculators have different time preferences. Stock market volatility tends to decrease with disagreement. While the stock market risk premium increases and is countercyclical due to household non participation in financial markets, disagreement has no effect on the risk premium unless speculators have different time preferences."
Work in Progress
Applied Stochastic Portfolio Theory (joint with Johannes Ruf)
Portfolio Choice with Commodity ETFs (joint with Christoph Meinerding and Christian Schlag)
Portfolio Choice with Model Uncertainty (joint with Julian Thimme)
Expanded Term Structure Models (joint with Peter Feldhuetter and Christian Heyerdahl-Larsen)
Revisiting the Predictability of Stock Market Returns (joint with Paul Ehling and Christian Heyerdahl-Larsen)
Inflation Disagreement and its Effect on Consumption and Investment (joint with Francisco Gomes and Christian Heyerdahl-Larsen)
Option Pricing with Model Uncertainty (joint with Christian Heyerdahl-Larsen and Johannes Ruf)