Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints

The consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out to its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stock holders with preferences that incorporate elements of the prospect theory developed by Kahneman and Tversky (1979). In addition to consumption, stockholders consider fluctuations in their financial wealth explicitly when making decisions. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 5.5% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle reported by Mehra and Prescott (1985).

The Effects of Credit Risk on Dynamic Portfolio Management: A New Computational Approach

The study investigates the role of credit risk in a continuous time stochastic asset allocation model, since the traditional dynamic framework does not provide credit risk flexibility. The general model of the study extends the traditional dynamic efficiency framework by explicitly deriving the optimal value function for the infinite horizon stochastic control problem via a weighted volatility measure of market and credit risk. The model's optimal strategy was then compared to that obtained from a benchmark Markowitz-type dynamic optimization framework to determine which specification adequately reflects the optimal terminal investment returns and strategy under credit and market risks. The paper shows that an investor's optimal terminal return is lower than typically indicated under the traditional mean-variance framework during periods of elevated credit risk. Hence I conclude that, while the traditional dynamic mean-variance approach may indicate the ideal, in the presence of credit-risk it does not accurately reflect the observed optimal returns, terminal wealth and portfolio selection strategies.

International Transfer Pricing for Goods and Intangible Asset Licenses in a Decentralized Multinational Corporation: Review and Extensions

We review and extend the core literature on international transfer price manipulation to avoid or evade taxes. Under negotiated transfer pricing with a viable bargaining structure, including performance evaluation disconnected from the transfer price, divisions voluntarily exchange accurate information to obtain firm-wide optimality, a result not dependent on restraint from exercising internal market power. For intangible licenses, a larger optimal profit shift for a given tax rate change strengthens incentives for transfer pricing abuse. In practice, an intangible's arm's length range is viewed as a guideline, a context where incentives for abuse materialize. Transfer pricing for intangibles obliges greater tax authority scrutiny.

Consumption asymmetry and the stock market: New evidence through a threshold adjustment model

This paper investigates whether stock market wealth affects real consumption asymmetrically through a threshold adjustment model. The empirical findings for the US show that wealth produces an asymmetric effect on real consumption, with negative 'news' affecting consumption less than positive 'news.' Thus, policy makers may want to focus more attention on preventing asset 'bubbles' than on responding to negative asset shocks.

Transfer Pricing in the Decentralized Multinational Corporation

This paper considers how the multinational corporation's transfer price responds to changes in international corporate effective tax rates. It extends the decentralized decision-making analysis of transfer pricing in the context of different tax rates. It adopts and extends Bond's (1980) model of the decentralized multinational corporation that assumes centralized transfer pricing. The direction of transfer price change is as expected, while the magnitude of change is likely to be less than predicted by the Horst (1971), centralized decision-making model. The paper extends the model further by assuming negotiated transfer pricing, where the analysis is partitioned into perfect and imperfect information cases. The negotiated transfer pricing result reverts to the Horst (1971), or centralized decision-making, result, under perfect information. Under imperfect information, the centralized decision-making result obtains when top management successfully informs division general managers or it successfully implements a non-monetary reward scheme to encourage division general managers to cooperate. Under simplifying assumptions, centralized decision-making dominates decentralized decision-making, while negotiated transfer pricing weakly dominates centralized transfer pricing.

Monetary Policy in a Portfolio Balance Model with Endogenous Physical Capital

We develop a portfolio balance model with real capital accumulation. The introduction of real capital as an asset as well as a good produced and demanded by firms enriches extant portfolio balance models of exchange rate determination. We show that expansionary monetary policy causes exchange rate overshooting, not once, but twice; the secondary repercussion comes through the reaction of firms to changed asset prices and the firms' decisions to invest in real capital. The model sheds further light on the volatility of real and nominal exchange rates, and it suggests that changes in corporate sector profitability may affect exchange rates through portfolio diversification in corporate securities.