Essays in Financial Economics

XIa, Shixiang

doi:https://doi.org/10.21985/n2-9199-1424

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Essays in Financial Economics

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Chapter 1 proposes a parsimonious two-country, two-good, and complete-market model featuring heterogeneous beliefs to address the Backus-Smith, volatility, and forward premium puzzles in international finance. The presence of the time-varying difference in beliefs has direct and indirect effects on equilibrium exchange rates. The direct effect appears as a wedge in the pricing kernels while the endogenous indirect effect operates through the dynamic reallocation of equilibrium consumption shares in response to the belief difference. With a general setup of the belief difference, the direct and indirect effects jointly help to qualitatively address these puzzles. In calibration, the model reconciles highly correlated pricing kernels with moderately correlated consumption growth rates. Moreover, the model generates a sizable currency risk premium and a disconnect between exchange rate changes and consumption growth differentials. Chapter 2 studies the implementation of Ross Recovery. The Recovery Theorem establishes a set of sufficient conditions for the unique resolution of the market's subjective belief and its risk preference. We show that the implementation of the Recovery Theorem via fitting an effective Arrow-Debreu (AD) price matrix and the market's characteristics recovered thereof depend endogenously and crucially on a subjectively specified dimension for that matrix. When the subjective specification is not chosen in accordance with data sampling frequency and state dynamic, it leads to inconsistencies in both AD prices and the recovered characteristics for the market. To circumvent this elusive estimation of the AD price matrix, we propose a new and consistent recovery implementation procedure that combines the original insight of the Recovery Theorem with the finite differences of the risk-neutral state dynamic.

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