Dynamic Asset Pricing with Funding-Shortfall Risk

Majid Hasan, PhD

Abstract :

Funding-Shortfall Risk and Asset Prices in General Equilibrium : Institutional investors, such as pensions and insurers, are typically constrained to hold enough wealth to be able to make their contractually promised payments to fund beneficiaries, and face a funding-shortfall risk. We seek to explore the optimal asset allocation strategies for institutions facing this risk, and its effects on asset prices. The constraint introduces two distinct regions in the economy, uncon- strained and constrained, with the possibility of transitioning from the constrained to the unconstrained region, which leads to a two-factor asset pricing model. The funding-shortfall risk increases the conditional equity premium and Sharpe ratio, which evolve counter-cyclically, but decreases the conditional volatility of equity returns, which evolves cyclically. The constrained institution may optimally hold an under-diversified portfolio, and simultaneously increases its demand for the risk- free and higher-risk assets relative to medium-risk assets, inducing a bubble-like behaviour in the prices of higher-risk assets. The dynamics of required payouts can induce predictability in the dynamics of conditional moments of asset returns. The term structure of interest rates is predominantly upward sloping, but can change shape upon shocks to the growth rate of aggregate dividend relative to the growth rate of minimum payouts, providing a new channel through which the business cycle may affect the shape of the term structure of riskfree rates.

Rational Mispricing with Unpredictable Demand Shocks : Movements in prices depend both on innovations to cash flows and changes in discount rates, which can be modelled as fluctuations in the cross-sectional distribution of wealth across an unchanging set of investment objectives. This paper explores the risk that arises when investors do not have perfect information about the wealth distribution, and, as a result, cannot forecast prices accurately. To take into account this risk, investors plan their consumption for all realisations of the wealth distribution according to their subjective beliefs. This makes markets highly incomplete, and derivative assets become non-redundant. Derivatives serve a dual purpose: they allow investors to adjust consumption for different realisations of the wealth distribution, and provide information required to implement optimal allocation decisions. Asset prices, and expected returns, depend on the sensitivity of stochastic discount factor and assets' payoffs to the wealth distribution. Prices of derivatives deviate from the expected cost of creating synthetic derivatives through dynamic trading, creating apparent mispricings between derivatives and primary assets. The imprecise information about the wealth distribution can induce an additional demand for dynamic trading, so that passive investment strategies are no longer optimal. Our results also have implications for arbitrage activity, informational efficiency of prices, and the role of financial innovation.

Publication date of the thesis

Thesis committee

Supervisor: Raman Uppal, EDHEC Business School

External reviewer: Jakša Cvitanić, Caltech

Other committee member: Laurent Calvet, EDHEC Business School