Philipp Karl
ILLEDITSCH

Published or Forthcoming Papers

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.


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.


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. 


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).


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

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.


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.

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