We study an economy without bubbles in which expectations about future discount rates can become self-fulfilling because asset valuations redistribute wealth across different investor cohorts. For such redistribution to take place, the wealth of arriving and existing cohorts must react differently to discount rates, and in addition only the existing agents are marginal in financial markets. The self-fulfilling nature of discount rate expectations means that the economy can address several well-documented empirical asset-pricing facts (excessive volatility, return predictability, low interest rate level and volatility), while all real quantities (aggregate consumption and dividend growth) are smooth.

We analyze the design and renegotiation of covenants in debt contracts as a specific example of the contractual assignment of property rights under asymmetric information. Specifically, we consider a setting where managers are better informed than lenders regarding potential transfers from debt to equity associated with future investments. This simple adverse-selection problem leads to the allocation of greater ex ante decision rights to the creditor (the uninformed party), i.e., tighter covenants, than would follow under symmetric information. This corresponds well to empirical evidence indicating that covenants are very tight upon inception and are frequently waived (and never tightened) upon renegotiation.

[We analyze the design and renegotiation of covenants in debt contracts as a specific example of the contractual assignment of property rights under asymmetric information. Specifically, we consider a setting where managers are better informed than lenders regarding potential transfers from debt to equity associated with future investments. This simple adverseselection problem leads to the allocation of greater ex ante decision rights to the creditor (the uninformed party), i.e., tighter covenants, than would follow under symmetric information. This corresponds well to empirical evidence indicating that covenants are very tight upon inception and are frequently waived (and never tightened) upon renegotiation.]

In an overlapping-generations economy, the consumption growth of a given cohort member (the “marginal agent”) differs from the aggregate consumption growth. A cohort member is faced with long-run consumption uncertainty even in the absence of aggregate (and within-cohort) consumption risk. This uncertainty allows the model to account for several stylized asset-pricing facts (high market price of risk and volatility, return predictability, low and nonvolatile interest rate) despite deterministic macroeconomic aggregates and inequality measures that are contemporaneously uncorrelated with asset returns. We devise and implement a methodology to measure the marginal agent’s consumption growth and evaluate the model’s quantitative implications.

We study the implications of preference heterogeneity for asset pricing. We use recursive preferences in order to separate heterogeneity in risk aversion from heterogeneity in the intertemporal elasticity of substitution and an overlapping-generations framework to obtain a nondegenerate stationary equilibrium. We solve the model explicitly up to the solutions of ordinary differential equations and highlight the effects of overlapping generations and each dimension of preference heterogeneity on the market price of risk, interest rates, and the volatility of stock returns. We find that separating intertemporal elasticity of substitution and risk aversion heterogeneity can have a substantive impact on the model's (qualitative and quantitative) ability to address some key asset-pricing issues.

[In a model with heterogeneous-risk-aversion agents facing margin constraints, we show how securities' required returns increase in both their betas and their margin requirements. Negative shocks to fundamentals make margin constraints bind, lowering risk-free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding-liquidity crisis gives rise to "bases," that is, price gaps between securities with identical cash-flows but different margins. In the time series, bases depend on the shadow cost of capital, which can be captured through the interest-rate spread between collateralized and uncollateralized loans and, in the cross-section, they depend on relative margins. We test the model empirically using the credit default swap—bond bases and other deviations from the Law of One Price, and use it to evaluate central banks' lending facilities.]

An important feature of financial markets is that securities are traded repeatedly by asymmetrically informed investors. We study how current and future adverse selection affect the required return. We find that the bid-ask spread generated by adverse selection is not a cost, on average, for agents who trade, and hence the bid-ask spread does not directly influence the required return. Adverse selection contributes to trading-decision distortions, however, implying allocation costs, which affect the required return. We explicitly derive the effect of adverse selection on required returns, and show how our result differs from models that consider the bid-ask spread to be an exogenous cost.

We study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Due to the lack of inter-generational risk sharing, innovation creates a systematic risk factor, which we call “displacement risk.” This risk helps explain several empirical patterns, including the existence of the growth-value factor in returns, the value premium, and the high equity premium. We assess the magnitude of displacement risk using estimates of inter-cohort consumption differences across households and find support for the model.

We model how investors allocate between asset managers, managers choose portfolios of multiple securities, fees are set, and security prices are determined. Investors are indifferent between higher-cost informed managers and lower-cost uninformed managers, interpreted as passive managers as their portfolio is linked to the " expected market portfolio." We make precise Samuelson's dictum by showing that active investors reduce micro-inefficiencies more than they do macro-inefficiencies. In fact, all inefficiency arises from systematic factors when the number of assets is large. Further, we show how the costs of active and passive investing affect macro- and micro-efficiency, fees, and assets managed by active and passive managers. Our findings help explain the rise of delegated asset management and the resultant changes in financial markets.

We provide a model to explain how the interaction between the spot and lending markets for stocks can lead to abrupt changes in short selling activity. Furthermore, rational short sellers may choose to abandon the market even as mispricing widens. We document empirically that the dynamics of short selling are fat tailed and subject to abrupt changes, especially for the stocks that the model identifies as susceptible to such dynamics.