Financial Markets with Frictions and Belief Distortions

The three essays of this thesis investigate the role of frictions and belief distortions as determinants of asset prices and macroeconomic outcomes. The essays are the product of my PhD studies at the Department of Finance and the Center for Financial Frictions (FRIC) at CBS. The essays are self-contained and can be read independently.
In my first paper, Risk Neglect in the Corporate Bond Market, I present an equilibrium model of corporate bonds and stocks that distinguishes the effects of rational risk aversion from the effects of extrapolative beliefs on asset prices. From the model, I construct a novel measure of credit market sentiment denoted yield-for-risk, which measures the compensation investors require for credit risk in the cross section of corporate bonds. In a panel of bonds and stocks spanning more than 40 years, I find strong evidence of risk neglect; When yield-for-risk is low, the expected return on credit is low and the risk-return relationship inverts for both corporate bonds and stocks. The evidence is consistent with extrapolative beliefs, but inconsistent with canonical asset pricing models with rational expectations.
My second paper, Predictable Financial Crises (coauthored with Robin Greenwood, Samuel G. Hanson, and Andrei Shleifer), uses historical data on post-war financial crises around the world to show that financial crises are substantially more predictable than previously thought. Specifically, the combination of rapid credit and asset price growth over the prior three years, whether in the nonfinancial business sector or the household sector, is associated with about a 40% probability of entering a financial crisis within the next three years. Our evidence cuts against the view that financial crises are unpredictable “bolts from the sky” and points toward the Kindleberger-Minsky view that crises are the byproduct of predictable, boom-bust credit cycles. As in my first essay, the evidence suggests that extrapolative beliefs are important determinants of economic outcomes. The predictability favors macroprudential policies that lean against incipient credit-market booms.
My last paper, Asset Driven Insurance Pricing (coauthored with Benjamin Knox), considers the invest-ment strategies of insurance companies and their impact on the pricing of insurance contracts. In the paper, we develop a theory that connects insurance premiums, insurance companies’ investment behavior, and equi-librium asset prices. Consistent with the model’s key predictions we show empirically that: (1) insurers with more stable insurance funding take more investment risk and, therefore, earn higher average investment returns; (2) insurance premiums are lower when expected investment returns are higher, both in the cross section of insurance companies and in the time series. We show our results hold for both life insurance compa-nies and, using a novel approach, for property and casualty insurance companies. Consistent findings across different regulatory frameworks helps identify asset-driven insurance pricing while controlling for alternative explanations.