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On the empirical relevance of cointegration between stock market returns and labor income on optimal portfolio choice
Stockholm University, Faculty of Social Sciences, Department of Economics.
(English)Manuscript (preprint) (Other academic)
Abstract [en]

I investigate the empirical relevance of cointegration between labor income and (cumulative) equity returns on the optimal choice between equity and risk-free bonds for finitely lived households facing an exogenously given economic environment. Benzoni et al. (2007) showed that such cointegration implies that households should save only in risk-free bonds when young, and increase the share of equity in the portfolio as they grow older. Since this result is a reversal of conventional wisdom, I investigate if the empirical cointegration relationship is strong enough to be relevant when households make investment decisions. Using an economic environment estimated on US data between 1929-2016, I find that cointegration exists, but that it is not strong enough to result in an increasing equity share with age.

Keywords [en]
portfolio choice, cointegration, long run risk, life cycle, vector error correction
National Category
Economics
Research subject
Economics
Identifiers
URN: urn:nbn:se:su:diva-155080OAI: oai:DiVA.org:su-155080DiVA, id: diva2:1196770
Available from: 2018-04-11 Created: 2018-04-11 Last updated: 2018-04-11Bibliographically approved
In thesis
1. Public Policy, Household Finance and the Macroeconomy
Open this publication in new window or tab >>Public Policy, Household Finance and the Macroeconomy
2018 (English)Doctoral thesis, comprehensive summary (Other academic)
Abstract [en]

The thesis contains four separate essays, spanning questions of the interaction between public policy, household finance and the macroeconomy. How does public policy affect macroeconomic outcomes, and the choices and welfare of households, and what are households’ optimal financial responses to changes in macroeconomic environments? Furthermore, the thesis includes a development of a method, which is helpful to answer questions like the ones stated above. 

The first essay, Optimal Public Policy in a Multi-Sector Economy with Asymmetric Shocks, shows how fiscal policy can complement monetary policy. It is shown that fiscal policy can be used to improve macroeconomic outcomes and make the economy more efficient. Since fiscal policy, in general, includes more instruments than monetary policy, it is possible to neutralize several frictions in the economy simultaneously. This is shown in a general equilibrium model with dynastic households, where firms face monopolistic competition, sticky prices, productivity shocks and cost-push shocks. 

The second essay, On the Design of Mortgage Default Legislation, asks how different types of mortgage contracts interact with different types of mortgage default policies regarding the probability of a default on home-owner’s mortgage. The different types of mortgage contracts analyzed are fixed rate annuity mortgages, adjustable rate amortized mortgages and adjustable rate non-amortized mortgages. The mortgage default policies span from non-recourse (where the mortgage lender takes all the default risk) to full recourse (where the borrower takes all the default risk). It is shown that a “borrower friendly” non-recourse policy is, as the one implemented in many parts of the United States, not necessarily borrower friendly due to its effect on the risk premium. This is investigated in a model with finitely lived households and an endogenous risk premium. 

The third essay, On The Empirical Relevance of Cointegration Between Stock Market Returns and Labor Income on Optimal Portfolio Choice, investigates how finitely lived households optimally choose a portfolio consisting of risk-free bonds and risky equity, and how this choice is affected by the long-run correlation between risky (cumulative) equity returns and stochastic labor income. More specifically, I investigate if the empirical cointegration (long-run correlation) between the two variables is strong enough to affect the optimal portfolio choice.  It is shown that it is not. Cointegration exists between the two variables, but the speed-of-adjustment back to the cointegration equilibrium is to slow to have a significant effect on the households’ optimal portfolios. 

The fourth essay, Solving Dynamic Programming Problems Using Stochastic Grids and Nearest-Neighbor Interpolation, describes a new computational method, which is used in the second and third essays. The method is developed to solve models with finitely lived households who face a complex economic environment. Post-state decision rules for the households are used together with simulated stochastic grids over the exogenous variables. By simulating the grids it is possible to reduce the number of grid points that the model is solved for, thereby making it significantly faster to solve models with many exogenous state variables. It is shown that it is possible to solve non-linear life-cycle models including at least eight state variables relatively quickly on a standard desktop computer.

Place, publisher, year, edition, pages
Stockholm: Department of Economics, Stockholm University, 2018
Series
Dissertations in Economics, ISSN 1404-3491 ; 2018:3
Keywords
Public policy, household finance, macroeconomics, numerical models, housing finance
National Category
Economics
Research subject
Economics
Identifiers
urn:nbn:se:su:diva-155083 (URN)978-91-7797-250-1 (ISBN)978-91-7797-251-8 (ISBN)
Public defence
2018-05-29, De Geersalen, Geovetenskapens hus, Svante Arrhenius väg 14, Stockholm, 13:00 (English)
Opponent
Supervisors
Note

At the time of the doctoral defense, the following papers were unpublished and had a status as follows: Paper 1: Manuscript. Paper 2: Manuscript. Paper 3: Manuscript. Paper 4: Manuscript.

Available from: 2018-05-04 Created: 2018-04-11 Last updated: 2018-04-20Bibliographically approved

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