Research Review | 12.14.2011 | Asset Pricing & The Business Cycle

Implied Risk Premium and the Business Cycle: You Can’t Always Get What You Want
Georg Bestelmeyer (University of Cologne), et al. | December 1, 2011
We analyze the link between investor’s risk premia demands and overall business conditions. In contrast to previous studies we focus on ex-ante risk premia expectations implied in market prices and earnings forecasts rather than ex-post realized excess returns. We find that implied risk premia are counter-cyclical and strongly driven by the economic environment. On average, implied risk premia are higher (lower) when the economy is contracting (expanding). In contrast, realized excess returns on a monthly frequency do not show this pattern over our sample period March 1983 to December 2009. In addition, implied risk premia are highly sensitive to macroeconomic risk factors such as term- and default spreads. Our findings emphasize that implied risk premia are time varying and strongly tied to the business cycle – much more than realized excess returns.

Do Mood Swings Drive Business Cycles and is it Rational?
Paul Beaudry (University of British Columbia), et al. | December 2011 (Dallas Fed)
This paper provides new evidence in support of the idea that bouts of optimism and pessimism drive much of US business cycles. In particular, we begin by using sign-restriction based identification schemes to isolate innovations in optimism or pessimism and we document the extent to which such episodes explain macroeconomic fluctuations. We then examine the link between these identified mood shocks and subsequent developments in fundamentals using alternative identification schemes (i.e., variants of the maximum forecast error variance approach). We find that there is a very close link between the two, suggesting that agents’ feelings of optimism and pessimism are at least partially rational as total factor productivity (TFP) is observed to rise 8-10 quarters after an initial bout of optimism. While this later finding is consistent with some previous findings in the news shock literature, we cannot rule out that such episodes reflect self-fulfilling beliefs. Overall, we argue that mood swings account for over 50% of business cycle fluctuations in hours and output.
When Credit Bites Back: Leverage, Business Cycles, and Crises
Oscar Jorda (University of California Davis), et al. | November 2011 (San Francisco Fed)
This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, lending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle.
Confidence Matters for Nowcasting GDP: Euro Area and U.S. Evidence from a PMI-Based Model
Gabe De Bondt (ECB) and Stefano Schiaffi (Bocconi University) | November 17, 2011
This paper assesses the nowcasting performance of confidence in a one-equation model based on the Purchasing Managers Index (PMI). We look at the interactions between the PMI and confidence and the reasons why confidence affects real GDP growth besides the PMI. Moreover, we explain why our model fits euro area and US data differently. Finally, we test for a possible differential relevance of confidence across the business cycle using a smooth transition model. The results underline that confidence always matters in nowcasting the euro area and the US output, both in good and in bad times.
Skyscraper Height and the Business Cycle: International Time Series Evidence
Jason Barr (Rutgers), et al. | December 2011
This paper is the first to rigorously test how height and output co-move. Because builders can use their buildings for non-rational or non-pecuniary gains, it is widely believed that (a) the most severe forms of height competition occur near the business cycle peaks and (b) that extreme height are examples of developers “gone wild.” We find virtually no support for either of these popularly held claims. First we look at both the announcement and completion dates for record breaking buildings and find there is very little correlation with the business cycle. Second, cointegration and Granger causality tests show that height and output are cointegrated and that height does not Granger cause output. These results are robust for the United States, Canada, China and Hong Kong.
The behaviour of small cap vs. large cap stocks in recessions and recoveries: Empirical evidence for the United States and Canada
Lorne Switzer (Concordia University) | North American Journal of Economics and Finance (2010)
This paper examines the relative performance of small-caps vs. large caps surrounding periods of peaks and troughs of economic activity, and reexamines the relationship between the small firm anomaly and the business cycle. Small-cap firms outperform large caps over the year subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag. US style based large caps perform better over peaks, but there is no dominant category across size and book to market asset classes over troughs. The US small cap premium is related to default risk, although recessions per se do not on average impact on this premium. Default risk and the inflation risk differential between Canada and the US significantly impact on the Canada–US equity premium. Abnormal positive performance observed for US small caps in the recent (post 2001) period as well as for the long horizon is attributable to the small cap growth cohort. Canadian small firm stocks also exhibit significantly positive performance in the post 2001 period.