Learning about Risk and Return: A Simple Model of Bubbles and Crashes

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock’s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents’ estimates of risk.

Avoidance Policies – A New Conceptual Framework

This paper develops a general theoretical framework within which a heterogeneous group taxpayers confront a market that supplies a variety of schemes for reducing tax liability, and uses this framework to explore the impact of a wide range of anti-avoidance policies. Schemes differ in their legal effectiveness and hence in the risks to which they expose taxpayers - risks which go beyond the risk of audit considered in the conventional literature on evasion. Given the individual taxpayer’s circumstances, the prices charged for the schemes and the policy environment, the model predicts (i) whether or not any given taxpayer will acquire a scheme, and (ii) if they do so, which type of scheme they will acquire. The paper then analyses how these decisions, and hence the tax gap, are influenced by four generic types of policy: Disclosure – earlier information leading to faster closure of loopholes; Penalties – introduction of penalties for failed avoidance; Policy Design – fundamental policy changes that design out opportunities for avoidance; Product Register - the introduction of GAARs or mini-GAARs that give greater clarity about how different types of scheme will be treated. The paper shows that when considering the indirect/behavioural effects of policies on the tax gap it is important to recognise that these operate on two different margins. First policies will have deterrence effects – their impact on the quantum of taxpayers choosing to acquire different types schemes as distinct to acquiring no scheme at all. There will be a range of such deterrence effects reflecting the range of schemes available in the market. But secondly, since different schemes generate different tax gaps, policies will also have switching effects as they induce taxpayers who previously acquired one type of scheme to acquire another. The first three types of policy generate positive deterrence effects but differ in the switching effects they produce. The fourth type of policy produces mixed deterrence effects.

Inequality and Risk-Taking Behaviour

This paper investigates social influences on attitudes to risk and offers an evolutionary explanation of risk-taking by young low-ranked males. Becker, Murphy and Werning (2005) found that individuals about to participate in a status tournament may take fair gambles even though they are risk averse in both wealth and status. Here their model is generalised by use of the insight of Hopkins and Kornienko (2010) that in a tournament or status competition one can consider equality in terms of the status or rewards available as well as in initial endowments. While Becker et al. found that risk-taking is increasing in the equality of initial endowments, it is found here that it is increasing in the inequality of rewards in the tournament. Further, it is shown that the poorest will be risk loving if the lowest level of status awarded is sufficiently low. Thus, the disadvantaged in society rationally engage in risky behavior when social rewards are sufficiently unequal. Finally, as greater inequality in terms of social status induces gambling, it can cause greater inequality of wealth.

Effects of stress on economic decision-making: Evidence from laboratory experiments

The ways in which preferences respond to the varying stress of economic environments is a key question for behavioral economics and public policy. We conducted a laboratory experiment to investigate the effects of stress on financial decision making among individuals aged 50 and older. Using the cold pressor task as a physiological stressor, and a series of intelligence tests as cognitive stressors, we find that stress increases subjective discounting rates, has no effect on the degree of risk-aversion, and substantially lowers the effort individuals make to learn about financial decisions.

Modeling Dependence Structure and Forecasting Portfolio Value-at-Risk with Dynamic Copulas

We study the asymmetric and dynamic dependence between financial assets and demonstrate, from the perspective of risk management, the economic significance of dynamic copula models. First, we construct stock and currency portfolios sorted on different characteristics (ex ante beta, coskewness, cokurtosis and order flows), and find substantial evidence of dynamic evolution between the high beta (respectively, coskewness, cokurtosis and order flow) portfolios and the low beta (coskewness, cokurtosis and order flow) portfolios. Second, using three different dependence measures, we show the presence of asymmetric dependence between these characteristic-sorted portfolios. Third, we use a dynamic copula framework based on Creal et al. (2013) and Patton (2012) to forecast the portfolio Value-at-Risk of long-short (high minus low) equity and FX portfolios. We use several widely used univariate and multivariate VaR models for the purpose of comparison. Backtesting our methodology, we find that the asymmetric dynamic copula models provide more accurate forecasts, in general, and, in particular, perform much better during the recent financial crises, indicating the economic significance of incorporating dynamic and asymmetric dependence in risk management.