Research

2008
Brunnermeier, Markus K, Stefan Nagel, and Lasse H Pedersen. “Carry Trades and Currency Crashes”. Ed. Kenneth Rogoff, Michael Woodford, & Daron Acemoglu. NBER Macroeconomics Annual 2008 23 (2008): , 23, 313-347. Print.Abstract

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carry_trades_currency_crashes_slides.pdf carry_trades_currency_crashes.pdf

Currency crash risk caused by sudden unwinding of carry trades may discourage speculators from taking on large enough positions to enforce UIP.

Brunnermeier, Markus K, Filippos Papakonstantinou, and Jonathan A Parker. “An Economic Model of the Planning Fallacy”. 2008: n. pag. Print.Abstract

People tend to underestimate the work involved in completing tasks and consequently finish tasks later than expected or do an inordinate amount of work right before projects are due. We present a theory in which people underpredict and procrastinate because the ex-ante utility benefits of anticipating that a task will be easy to complete outweigh the average ex-post costs of poor planning. We show that, given a commitment device, people self-impose deadlines that are binding but require less smoothing of work than those chosen by a person with objective beliefs. We test our theory using extant experimental evidence on differences in expectations and behavior. We find that reported beliefs and behavior generally respond as our theory predicts. For example, monetary incentives for accurate prediction ameliorate the planning fallacy while incentives for rapid completion aggravate it.

planning_fallacy.pdf planning_fallacy_slides.pdf
Brunnermeier, Markus K, and Christian Julliard. “Money Illusion and Housing Frenzies”. The Review of Financial Studies 21 (2008): , 21, 135-180. Print.Abstract

A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account the fact that inflation lowers future real mortgage costs. We decompose the price-rent ratio into a rational component-meant to capture the "proxy effect" and risk premia–and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.

money_illusion_housing_frenzies.pdf slides.pdf

The confusion between changes in nominal and real interest rates boosts real house prices when inflation declines.

Brunnermeier, Markus K, and Stefan Nagel. “Do Wealth Fluctuations Generate Time-Varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation”. The American Economic Review 98 (2008): , 98, 713-736. Print.Abstract

We use data from the Panel Study of Income Dynamics to investigate how households' portfolio allocations change in response to wealth fluctuations. Persistent habits, consumption commitments, and subsistence levels can generate time-varying risk aversion with the consequence that when the level of liquid wealth changes, the proportion a household invests in risky assets should also change in the same direction. In contrast, our analysis shows that the share of liquid assets that households invest in risky assets is not affected by wealth changes. Instead, one of the major drivers of household portfolio allocation seems to be inertia: households rebalance only very slowly following inflows and outflows or capital gains and losses.

time_varying_riskaversion.pdf

Wealth shocks do not change the fraction individuals invest in risky assets, suggesting that individuals' risk aversion is not time-varying.

2007
Brunnermeier, Markus K, Christian Gollier, and Jonathan A Parker. “Optimal Beliefs, Asset Prices, and the Preference for Skewed Returns”. The American Economic Review 97 (2007): , 97, 159-165. Print.Abstract

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optimal_beliefs_skewed_returns.pdf

Different households overinvest in different positively skewed assets, making portfolio returns idiosyncratically skewed and lowering returns on these skewed assets.

2005
Brunnermeier, Markus K. “Information Leakage and Market Efficiency”. Review of Financial Studies 18 (2005): , 18, 417-457. Print.Abstract

This article analyzes the effects of information leakage on trading behavior and market efficiency. A trader who receives a noisy signal about a forthcoming public announcement can exploit it twice. First, when he receives it, and second, after the public announcement since he knows best the extent to which his information is already reflected in the pre-announcement price. Given his information he expects the price to overshoot and intends to partially revert his trade. While information leakage makes the price process more informative in the short-run, it reduces its informativeness in the long-run. The analysis supports Securities and Exchange Commission's Regulation Fair Disclosure.

information_leakage.pdf

Information leakage lowers market efficiency in the long run.

Brunnermeier, Markus K, and Jonathan A Parker. “Optimal Expectations”. The American Economic Review 95 (2005): , 95, 1092-1118. Print.Abstract

Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they are optimistic. This paper studies utility-based biases in beliefs by supposing that beliefs maximize average felicity, optimally balancing this benefit of optimism against the costs of worse decision making. A small optimistic bias in beliefs typically leads to first-order gains in anticipatory utility and only second-order costs in realized outcomes. In a portfolio choice example, investors overestimate their return and exhibit a preference for skewness; in general equilibrium, investors' prior beliefs are endogenously heterogeneous. In a consumption-saving example, consumers are both overconfident and over optimistic.

optimal_expectations.pdf optimal_expectations_slides.pdf

A structural model of "optimal" belief distortions due to anticipatory utility.

Brunnermeier, Markus K, and Lasse Heje Pedersen. “Predatory Trading”. The Journal of Finance 60 (2005): , 60, 1825-1863. Print.Abstract

This paper studies predatory trading, trading that induces and/or exploits the need of other investors to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buy back the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader's crisis, and the crisis can spill over across traders and across markets.

predatory_trading.pdf predatory_trading_slides.pdf

When a large trader has to liquidate, "predators" also sell and withdraw liquidity. This leads to price overshooting and systemic risk.

2004
Brunnermeier, Markus K, and Stefan Nagel. “Hedge Funds and the Technology Bubble”. The Journal of Finance 59 (2004): , 59, 2013-2040. Print.Abstract

This paper documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage.

hedgefunds_bubble.pdf hedgefunds_bubble_slides.pdf

Hedge funds were riding the technology bubble instead of exerting a price correcting force.

Brunnermeier, Markus K. “Learning to Reoptimize Consumption at New Income Levels: A Rationale for Prospect Theory”. Journal of the European Economic Association 2 (2004): , 2, 98-114. Print.Abstract

This paper provides a theoretical rationale for three experimental results of Prospect Theory: risk preferences are over gains and losses, loss aversion, and diminishing sensitivity. We consider a (boundedly rational) decision maker who does not find her new optimal consumption bundle with certainty when she is faced with a new income level. This alters her indirect utility function and makes her more risk averse at her current reference income level and less risk averse for a range of incomes below her reference income level.

prospect_theory.pdf

Rationalizes three elements of Prospect Theory.

2003
Abreu, Dilip, and Markus K Brunnermeier. “Bubbles and Crashes”. Econometrica 71 (2003): , 71, 173-204. Print.Abstract

We present a model in which an asset bubble can persist despite the presence of rational arbitrageurs. The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period. Since the derived trading equilibrium is unique, our model rationalizes the existence of bubbles in a strong sense. The model also provides a natural setting in which news events, by enabling synchronization, can have a disproportionate impact relative to their intrinsic informational content.

bubbles_crashes.pdf bubbles_crashes_slides.pdf

Bubbles persist since each rational arbitrageur does not know when other arbitrageurs will attack.

2002
Abreu, Dilip, and Markus K Brunnermeier. “Synchronization risk and delayed arbitrage”. Journal of Financial Economics 66 (2002): , 66, 341-360. Print.Abstract

We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs “time the market” rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run.

synchronization_risk.pdf

Models the Wile E. Coyote effect, since synchronization risk leads to market timing by arbitrageurs and delays arbitrage.

1999
Brunnermeier, Markus K. “Contrasting Different Forms of Price Stickiness: An Analysis of Exchange Rate Overshooting and the Beggar Thy Neighbour Policy”. 1999: n. pag. Print.Abstract

This paper considers a two country economy similar to that in Obstfeld and Rogoff (1995). We build on their model by distinguishing between sticky retail prices, sticky wholesale prices and sticky wages. We find that conclusions about whether monetary shocks lead to exchange rate overshooting and spillovers on foreign production and consumption depend crucially on the form of price stickiness assumed in the economy. Sticky retail prices not only allow for a profitable Beggar Thy Neighbour Policy but also lead to exchange rate overshooting. Although the outcome is similar to the seminal work by Dornbusch (1976), the driving force in our model is quite different. With sticky retail prices, the exchange rate overshoots even though the interest rate parity may not even hold in equilibrium. These results are in sharp contrast to the outcomes under the sticky wholesale prices scenario wherein prices are fixed in the producers currency. Contrary to the spirit of the Beggar Thy Neighbour Policy, an unexpected money expansion benefits inhabitants in the other country as well. The interest rate parity always hold in equilibrium and there is no exchange rate overshooting.

sticky9.pdf
Huddart, Steven, John S Hughes, and Markus Brunnermeier. “Disclosure requirements and stock exchange listing choice in an international context”. Journal of Accounting and Economics 26 (1999): , 26, 237 - 269. Print.Abstract

We use a rational expectations model to examine how public disclosure requirements affect listing decisions by rent-seeking corporate insiders, and allocation decisions by liquidity traders seeking to minimize trading costs. We find that exchanges competing for trading volume engage in a ‘race for the top’ whereunder disclosure requirements increase and trading costs fall. This result is robust to diversification incentives of risk-averse liquidity traders, institutional impediments that restrict the flow of liquidity, and listing costs. Under certain conditions, unrestricted liquidity flows to low disclosure exchanges. The consequences of cross-listing also are modeled.

competition_among_exchanges.pdf

Competition among exchanges leads to a "race to the top" in disclosure standards.

Pages