CONNECTING THEORY AND EMPIRICS FOR ANIMAL SPIRITS, RETURNS AND INTEREST RATES: A CLARIFICATION OF “RISK-FREE RATES AND ANIMAL SPIRITS IN FINANCIAL MARKETS”

I clarify and combine the results of Ilomäki (2016a) and Ilomäki (2016b) and find several interesting conclusions. First, the effect of the animal spirits component to the expected returns of investors depends on the risk-free rate. Second, there must be an upper limit for the risk-free rate, where the component that reduces the expected returns of informed investors in Ilomäki (2016a) disappears. Third, the empirical results of Ilomäki (2016b) indicates that the break-even level is as low as 3%.

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RISK-FREE RATES AND ANIMAL SPIRITS IN FINANCIAL MARKETS

Annals of Financial Economics ◽

10.1142/s2010495216500111 ◽

2016 ◽

Vol 11 (03) ◽

pp. 1650011 ◽

Cited By ~ 2

Author(s):

JUKKA ILOMÄKI

Keyword(s):

Financial Markets ◽

Expected Returns ◽

Risk Averse ◽

Animal Spirits ◽

Local Risk ◽

Global Stock Markets ◽

Animal Spirit ◽

Risk Free Rate ◽

Global Stock ◽

Free Rate

We show analytically that animal spirit excess profits for uninformed investors fall (increase) when the risk-free rate rises (falls). In the theoretical analysis, we examine the expected returns of risk-averse, short-lived investors. In addition, we find empirically that the local risk-free rates explain 14% of the changes in the animal spirit excess profits in the global stock markets for the last 29 years when the animal spirits is characterized as a product of the trend-chasing rule.

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Principles for modelling financial markets

Journal of Applied Probability ◽

10.1017/s002190020010004x ◽

1996 ◽

Vol 33 (03) ◽

pp. 601-613 ◽

Cited By ~ 5

Author(s):

Eckhard Platen ◽

Rolando Rebolledo

Keyword(s):

Financial Markets ◽

Financial Market ◽

Real World ◽

Market Model ◽

Rate Of Return ◽

Probability Measures ◽

Market Clearing ◽

The Difference ◽

Risk Free Rate ◽

Free Rate

The paper introduces an approach focused towards the modelling of dynamics of financial markets. It is based on the three principles of market clearing, exclusion of instantaneous arbitrage and minimization of increase of arbitrage information. The last principle is equivalent to the minimization of the difference between the risk neutral and the real world probability measures. The application of these principles allows us to identify various market parameters, e.g. the risk-free rate of return. The approach is demonstrated on a simple financial market model, for which the dynamics of a virtual risk-free rate of return can be explicitly computed.

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IMPLICATION OF THE KELLY CRITERION FOR MULTI-DIMENSIONAL PROCESSES

International Journal of Theoretical and Applied Finance ◽

10.1142/s0219024910005693 ◽

2010 ◽

Vol 13 (01) ◽

pp. 93-112 ◽

Cited By ~ 1

Author(s):

YINGDONG LV ◽

BERNHARD K. MEISTER

Keyword(s):

Financial Markets ◽

Diffusion Processes ◽

General Setting ◽

Optimal Investment ◽

Investment Strategy ◽

Short Term ◽

Kelly Criterion ◽

Optimal Investment Strategy ◽

Risk Free Rate ◽

Free Rate

In this paper, we study the Kelly criterion in the continuous time framework building on the work of E.O. Thorp and others. The existence of an optimal strategy is proven in a general setting and the corresponding optimal wealth process is found. A simple formula is provided for calculating the optimal portfolio in terms of drift, short term risk-free rate and correlations for a set of generic multi-dimensional diffusion processes satisfying some simple conditions. Properties of the optimal investment strategy are studied. The paper ends with a short discussion of the implications of these ideas for financial markets.

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Preferred and Non-Preferred Creditors

10.18235/0003109 ◽

2021 ◽

Author(s):

Tito Cordella ◽

Andrew Powell

Keyword(s):

Interest Rates ◽

Financial Institutions ◽

Low Cost ◽

International Financial Institutions ◽

Risk Free Rate ◽

Free Rate

International financial institutions (IFIs) generally enjoy preferred creditors treatment (PCT). Although PCT rarely appears in legal contracts, when sovereigns restructure bilateral or commercial debts, they normally pay IFIs in full. This paper presents a model where a creditor, such as an IFI, that can commit to lend limited amounts at the risk-free rate and can refrain from lending into arrears is always repaid and adds value. The analysis suggests that IFIs and market lenders can both enhance welfare, even if banning commercial borrowing can sometimes be optimal. To maintain their status, preferred lenders should offer low cost financing in volumes that are consistent with countries' incentives to repay even in bad states. This suggests such lenders should not differentiate lending interest rates according to risk and should not participate in the restructuring of commercial debt.

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How Much Do Investors Care About Macroeconomic Risk? Evidence from Scheduled Economic Announcements

Journal of Financial and Quantitative Analysis ◽

10.1017/s002210901300015x ◽

2013 ◽

Vol 48 (2) ◽

pp. 343-375 ◽

Cited By ~ 149

Author(s):

Pavel Savor ◽

Mungo Wilson

Keyword(s):

Interest Rates ◽

Risk Premium ◽

Asset Returns ◽

Precautionary Saving ◽

Macroeconomic News ◽

Macroeconomic Risk ◽

Equity Risk ◽

Sharpe Ratios ◽

Risk Free Rate ◽

Free Rate

AbstractStock market average returns and Sharpe ratios are significantly higher on days when important macroeconomic news about inflation, unemployment, or interest rates is scheduled for announcement. The average announcement-day excess return from 1958 to 2009 is 11.4 basis points (bp) versus 1.1 bp for all the other days, suggesting that over 60% of the cumulative annual equity risk premium is earned on announcement days. The Sharpe ratio is 10 times higher. In contrast, the risk-free rate is detectably lower on announcement days, consistent with a precautionary saving motive. Our results demonstrate a trade-off between macroeconomic risk and asset returns, and provide an estimate of the premium investors demand to bear this risk.

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A Puzzle of Excessive Equity Risk Premium and the Case of Poland

e-Finanse ◽

10.1515/fiqf-2016-0131 ◽

2016 ◽

Vol 12 (1) ◽

pp. 1-11

Author(s):

Paweł Kliber

Keyword(s):

Financial Markets ◽

Risk Premium ◽

Historical Review ◽

Theoretical Models ◽

Equity Risk ◽

The Difference ◽

Using Data ◽

Risk Free Rate ◽

Excessive Risk ◽

Free Rate

AbstractThe article presents a historical review of the literature related to the empirical problem of excessive risk premium. The risk premium (the difference between the return on equities and risk-free rate) observed in financial markets cannot be reconciled with theoretical models of financial markets - it is too high (“excessive”). We present the original model from the seminal work of Mehra and Prescott (1985), where this problem has been signaled. The article gives an overview of the main trends in the literature concerning this problem, of the proposed solutions and of the extension to the model. Finally, we consider the problem in the Polish context, estimating the original Mehra-Prescott model using data from the Polish financial market.

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Financial Innovation, Market Participation, and Asset Prices

Journal of Financial and Quantitative Analysis ◽

10.1017/s0022109000003975 ◽

2004 ◽

Vol 39 (3) ◽

pp. 431-459 ◽

Cited By ~ 25

Author(s):

Laurent Calvet ◽

Martín Gonzalez-Eiras ◽

Paolo Sodini

Keyword(s):

Financial Markets ◽

Interest Rates ◽

Lower Risk ◽

Management Practices ◽

Financial Innovation ◽

Risk Premia ◽

Expected Returns ◽

The Past ◽

Redundant Assets ◽

Diversified Portfolio

AbstractThis paper investigates the pricing effects of financial innovation in an economy with endogenous participation and heterogeneous income risks. The introduction of non-redundant assets endogenously modifies the participation set, reduces the covariance between dividends and participants' consumption and thus leads to lower risk premia. In multisector economies, financial innovation spreads across markets through the diversified portfolio of new entrants, and has rich effects on the cross-section of expected returns. The price changes can also lead some investors to leave the markets and give rise to non-degenerate forms of participation turnover. The model is consistent with several features of financial markets over the past few decades: substantial innovation, higher participation, significant turnover in investor composition, improved risk management practices, a slight increase in real interest rates, and a reduction in risk premia.

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Habit Persistence, Asset Returns, and the Business Cycle

The American Economic Review ◽

10.1257/aer.91.1.149 ◽

2001 ◽

Vol 91 (1) ◽

pp. 149-166 ◽

Cited By ~ 570

Author(s):

Michele Boldrin ◽

Lawrence J Christiano ◽

Jonas D. M Fisher

Keyword(s):

Business Cycle ◽

Interest Rates ◽

Substantial Improvement ◽

Output Growth ◽

Habit Persistence ◽

Business Cycle Model ◽

The Business Cycle ◽

Risk Free Rate ◽

Mean Risk ◽

Free Rate

Two modifications are introduced into the standard real-business-cycle model: habit preferences and a two-sector technology with limited intersectoral factor mobility. The model is consistent with the observed mean risk-free rate, equity premium, and Sharpe ratio on equity. In addition, its business-cycle implications represent a substantial improvement over the standard model. It accounts for persistence in output, comovement of employment across different sectors over the business cycle, the evidence of “excess sensitivity” of consumption growth to output growth, and the “inverted leading-indicator property of interest rates,” that interest rates are negatively correlated with future output. (JEL D10, E10, E20, G12)

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