Zurich Open Repository and Archive University of Zurich Main Library Strickhofstrasse 39 CH-8057 Zurich www.zora.uzh.ch Year: 2008 Three essays in financial economics Monnin, Pierre Abstract: PART 1: Stock price with consumption CAPM: an international comparison PART 2: Time variations in the equity premium: is it habit formation or loss aversion? PART 3: Common exposure and systemic risk in the banking sector Posted at the Zurich Open Repository and Archive, University of Zurich ZORA URL: https://doi.org/10.5167/uzh-6242 Dissertation Published Version Originally published at: Monnin, Pierre. Three essays in financial economics. 2008, University of Zurich, Faculty of Economics. Three essays in financial economics Abstract PART 1: Stock price with consumption CAPM: an international comparison PART 2: Time variations in the equity premium: is it habit formation or loss aversion? PART 3: Common exposure and systemic risk in the banking sector Three Essays in Financial Economics Dissertation for the Faculty of Economics, Business Administration and Information Technology of the University of Zurich to achieve the title of Doctor of Economics presented by Pierre Monnin from Develier JU approved at the request of Prof. Dr. Thorsten Hens Prof. Dr. Mathias Hoffmann The Faculty of Economics, Business Administration and Information Technology of the University of Zurich hereby authorises the printing of this Doctoral Thesis, without thereby giving any opinion on the views contained therein. Zurich, April 2, 2008 The Dean: Prof. Dr. H. P. Wehrli Preface This thesis is composed of three distinct essays with relatively disparate topics. Each essay constitutes an entity on its own and can therefore be read independently from the others. The first essay proposes a new method to compute the fundamental price of stocks. It also studies in detail the empirical link between the price observed on international markets and the estimated fundamental price. The second essay assesses the ability of recent behavioural models to match the path of excess returns observed on the American stock markets. Finally, the third essay, written with Nicole Allenspach, examines the evolutions of banks' common exposure to shocks and of systemic risk in the banking sector since 1993, as well as the link between them. During the long journey through this thesis, I constantly benefited from the support of my advisor Thorsten Hens. I am particularly thankful to him for systematically including me in the activities of his academic group, even if my particular situation as external PhD student tended to keep me away from university. I also thank him for giving me enough time to explore several ideas before fixing my attention on the three topics presented in this thesis. I am also extremely grateful to my co-advisor Mathias Hoffmann for his very pertinent comments, especially on the first essay of this thesis. I was also privileged to benefit from the very helpful and supportive environment of the Financial Stability Unit at the Swiss National Bank. I am particularly grateful to Bertrand Rime, who allowed me time and freedom to work on this thesis, probably sometimes at the expense of more "systemic- relevant" projects. I also thank Robert Bichsel for its relaxed, but dedicated, supervision during these years. This experience would not have been as interesting as it was without the motivating and stimulating conversations with my colleagues Ulrike Bilgram, Urs Birchler, Jürg Blum, Dorothe Bonjour, Matteo Facchinetti, Sonja Gerber, Jeannette Henggeler-Müller, Christian Hott, Hansjörg Lehmann, and Reto Nyffeler. I particularly enjoyed the collaboration with Nicole Allenspach, who worked with me on the third essay of this thesis. I also would like to thank my parents, Jacqueline and Daniel Monnin, to whom I am deeply indebted, not only for their support during these last years. They have always been a leading example for me and this thesis is, in i large part, the result of the exceptional and stimulating intellectual environment that they provided me with during my life. Finally, I would probably never have completed this work without my wife Nellie by my side during the last seven years. More than anybody else, she experienced with me the highs and lows of writing this thesis. Her constant encouragements and infinite patience were a great support and mean more than I can say. Zurich, March 2008 Pierre Monnin ii Contents Part I Stock Price with Consumption CAPM: An International Comparison 1. Introduction................................................................................. 4 2. The fundamental stock price equation ........................................ 8 3. Data........................................................................................... 16 4. Long-term evolution of PD ratios and of inflation ................... 16 5. Econometric methodology........................................................ 22 6. Estimated fundamental stock prices.......................................... 23 7. Do stock prices go back to their fundamental value? ............... 26 8. Is it really worth computing the CAPM fundamental price?.... 32 9. Conclusion ................................................................................ 36 Appendix A: Proofs ...................................................................... 38 Acknowledgements....................................................................... 40 References..................................................................................... 41 Part II Time Variations in the Equity Premium: Is it Habit Formation or Loss Aversion? 1. Introduction............................................................................... 48 2. Methodology............................................................................. 51 3. The different utility functions and their SDF............................ 55 4. Empirical results ....................................................................... 63 5. Conclusion ................................................................................ 78 Appendix A: Approximation for linear combinations of logarithms ..................................................................................... 79 Appendix B: Linearization of the internal habit marginal utility . 80 Appendix C: Linearization of the loss aversion marginal utility.. 82 Appendix D: Covariance with loss aversion function .................. 84 Acknowledgements....................................................................... 86 References..................................................................................... 86 iii Part III Common Exposure and Systemic Risk in the Banking Sector 1. Introduction............................................................................... 92 2. Methodology............................................................................. 95 3. Data......................................................................................... 101 4. Common exposure to shocks .................................................. 102 5. Evolution of systemic risk ...................................................... 105 6. Conclusion .............................................................................. 114 Appendix A: Reduced form asset and debt dynamics ................ 116 Appendix B: Simulation algorithm............................................. 117 Acknowledgements..................................................................... 117 References................................................................................... 118 iv List of Figures Part I 1. Stock prices and PD ratios ....................................................................... 17 2. Consumption and dividends..................................................................... 18 3. Consumer price indexes........................................................................... 19 4. Long-term evolution of PD ratios and of inflation .................................. 20 5. Fundamental stock prices and fundamental PD ratios............................. 25 6. Gap between the observed and the fundamental prices ........................... 26 7. Impulse-response function for the gaps ................................................... 29 8. Forecast accuracy of fundamental models............................................... 31 9. Forecast accuracy of alternative fundamental models............................. 34 10. Forecast accuracy for periods with large gaps....................................... 36 Part II 1. Unconditional vs. conditional moments .................................................. 50 2. Excess returns .......................................................................................... 66 3. Estimated conditional second moments................................................... 67 4. Estimated excess returns with CRRA...................................................... 68 5. Estimated excess returns with the internal habit formation..................... 70 6. Estimated excess returns with external habit formation model ............... 71 7. Estimated surplus and sensitivity............................................................. 73 8. Estimated excess returns with loss aversion A ........................................ 75 9. Gap with reference level and probability to fall under it (loss aversion A)................................................................................................... 75 10. Estimated excess returns