We develop a conditional version of the consumption capital asset pricing model (CCAPM) using the conditioning variable from the cointegrating relation among macroeconomic variables (dividend yield, term spread, default spread, and short-term interest rate). Our conditioning variable has a strong power to predict market excess returns in the presence of competing predictive variables. In addition, our conditional CCAPM performs about as well as Fama and French’s (1993) three-factor model in explaining the cross-section of the Fama and French 25 size and book-to-market sorted portfolios. Our specification shows that value stocks are riskier than growth stocks in bad times, supporting the risk-based story.
Understanding the time variation and cross-sectional variation in risk premiums has long been a central research question for financial economists. One way to gain an understanding of the nature of risk premiums is to examine the linkage between financial markets and the macroeconomy, because risk premiums should reflect macroeconomic risk. Cochrane's 2007 review article suggests the following in researching the interaction between macroeconomics and finance:
Bryant (1980) and Diamond and Dybvig (1983) have provided us with the classic benchmark model for a bank run. There, an individual bank engages in maturity transformation, using demand deposits to finance long term loans, which can be liquidated in the short term only at a cost. If too many agents claim short-term liquidity needs and withdraw their demand deposits, the value of the bank assets are thus not sufficient to meet these liquidity demands, in turn justifying even patient depositors to get their money while they can: a bank run ensues. One policy conclusion then is for a central bank to follow the classic Bagehot principle of committing to inject liquidity to illiquid but otherwise solvent bank, in order to stop bank runs.
The financial crisis of 2007 and 2008 is reminiscent of a bank run, but not quite, see Brunnermeier (2008). First, this was (with few exceptions) not a run of depositors on their local house bank, but a run of banks and money funds on some core financial institutions. Second, the health of some core financial institutions (I shall call them “core banks” for the purpose of this paper) was called into question not because of their commitment to costly- to-call long-term loans, but rather because of the questionable value of a variety of “exotic” securities, most notably their guarantees for particular tranches of mortgage-backed security derivatives and credit default swaps. These are assets which could be marked to market at least in principle. So, when a bank cannot repay its depositors because the market value of their assets is below the value of its liabilities, the traditional prescription is to declare the bank to be bankrupt and not to provide it with additional liquidity.
Despite numerous attempts, there have been limited successes in introducing mortgage securities in emerging markets on a significant scale. There are two major reasons for this result. First, the infrastructure requirements for mortgage security issuance are demanding, time consuming and costly. As discussed below, there are complex legal and regulatory pre-requisites for mortgage security issuance. It takes time and significant government support to develop the proper legal and regulatory infrastructure. This infrastructure also adds to the cost of funding through securities issuance, often making it uneconomic.
There are also challenging primary market requirements. Although not inconceivable, it is highly unlikely that mortgage securities can be successfully issued in countries with weak and under-developed primary mortgage markets. There must be a modicum of standardization in mortgage instruments, documents and underwriting, reasonable standards of servicing on the part of lenders and issuers and professional standards of property appraisal. Capital market funding can provide a strong incentive to improve primary market standards in these areas, but there can be no substitute for a certain degree of market development preceding introduction of new funding vehicles.
