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Abstract
This dissertation studies the role of macroeconomic risk for both asset pricing and international portfolio diversification.
The first essay shows, from the consumer's budget constraint, that expected future labor income growth rates should help predict U.S. quarterly stock market returns and explain the cross-section of average returns. I find that (a) fluctuations in expected future labor income are a strong predictor of both real stock returns and excess returns over a Treasury bill rate, (b) when this variable is used as conditioning information for the Consumption Capital Asset Pricing Model (CCAPM), the resulting linear factor model explains four fifths of the variation in observed average returns across the Fama and French portfolios and prices correctly the small growth portfolio.
The second essay, which is a joint work with Jonathan Parker, evaluates the central insight of the CCAPM that an asset's expected return is determined by its equilibrium risk to consumption. Rather than measure risk by the contemporaneous covariance of an asset's return and consumption growth, we measure risk by the covariance of an asset's return and consumption growth cumulated over many quarters following the return. While contemporaneous consumption risk explains little of the variation in average returns across the Fama and French portfolios, our measure of ultimate consumption risk explains a large fraction of this variation.
The third essay shows that in a non-representative agent model in which households face short selling constraints and both idiosyncratic and aggregate labor income risk, small differences in the correlation between aggregate labor income shocks and domestic and foreign stock market returns lead to a very large home bias in asset holdings. Calibrating this buffer-stock saving model to match both microeconomic and macroeconomic U.S. labor income data, I demonstrate that, consistent with the empirical literature, (a) investors that enter the stock market will initially specialize in domestic assets, (b) individual portfolios become more internationally diversified, adding foreign stocks one at a time, as the level of asset wealth increases, and (c) most importantly, the implied aggregate portfolio of U.S. investors shows a large degree of home bias consistent with observed levels.
