Actively managed mutual funds underperform the index and investors are recommended to invest in index funds since they give higher returns (Dagens Industri Debatt, 2010). In this thesis it is investigated if partly indexated portfolios with randomly selected stocks beat the benchmark index and thus are a valid option of portfolio construction for the individual investor. For this purpose sixteen portfolios are constructed partly by an index and partly by randomly selected stocks from the Swedish stock market in the time period of 2007.01.01 to 2010.01.01. Risk and return measures are used in order to analyse if the portfolios beat the benchmark index. The results are also compared to an index mutual fund in order to validate the results further. The results suggest that partly indexated portfolios with randomly selected stocks are able to outperform both the benchmark index and the comparing index mutual fund. When dividends were included in the portfolios all of the sixteen portfolios had beaten the benchmark index. The two stock portfolio is a valid alternative when investing in mutual funds since it has superior returns with only marginally higher risk than the benchmark index.

This dissertation addresses three issues in international macroeconomics. The first chapter examines optimal portfolio decisions in a monetary open economy DSGE model. In a complete market environment, Engel and Matsumoto (2005) find that sticky price can generate equity home bias. However, their result is sensitive to the structure of the financial market. In an incomplete market environment, we find “super home bias” in the equilibrium equity portfolio, which casts doubt on the ability of sticky price in describing the observed equity portfolios. We further show that introducing sticky wages helps to match the data. The second chapter analyzes the welfare impact of financial integration in a standard monetary open-economy model. Financial integration may have negative effects on welfare if integration occurs in the presence of nominal price rigidities and constraints on the efficient use of monetary policy. The reason is that financial integration leads to excessive terms of trade volatilities. From a policy perspective, the model implies that developing economies that are experiencing financial integration may attempt to alleviate the welfare cost of integration by stabilizing the exchange rate. This prediction is consistent with the widespread reluctance to following freely floating exchange rates among these economies. On the other hand, for advanced economies that have the ability to operate efficient inflation targeting monetary policies, financial integration is always beneficial. Thus, the model accounts for the observed acceleration in cross-border asset trade among advanced economies in the early 1990s as it was mainly the industrial countries that switched to an inflation targeting regime at the time. The third chapter uses an open-economy neoclassical growth model to explain the saving and investment behavior of the U.S. and a group of other OECD countries. We find that while the model explains investment quite well, it tends to overpredict U.S saving and underpredict saving in the rest of the world. We show that the closed-economy version of the model also predicts saving accurately but that is only because it imposes equality between saving and investment. In effect, the model explains investment not saving behavior.

This dissertation addresses three issues in international macroeconomics. The first chapter examines optimal portfolio decisions in a monetary open economy DSGE model. In a complete market environment, Engel and Matsumoto (2005) find that sticky price can generate equity home bias. However, their result is sensitive to the structure of the financial market. In an incomplete market environment, we find “super home bias” in the equilibrium equity portfolio, which casts doubt on the ability of sticky price in describing the observed equity portfolios. We further show that introducing sticky wages helps to match the data. The second chapter analyzes the welfare impact of financial integration in a standard monetary open-economy model. Financial integration may have negative effects on welfare if integration occurs in the presence of nominal price rigidities and constraints on the efficient use of monetary policy. The reason is that financial integration leads to excessive terms of trade volatilities. From a policy perspective, the model implies that developing economies that are experiencing financial integration may attempt to alleviate the welfare cost of integration by stabilizing the exchange rate. This prediction is consistent with the widespread reluctance to following freely floating exchange rates among these economies. On the other hand, for advanced economies that have the ability to operate efficient inflation targeting monetary policies, financial integration is always beneficial. Thus, the model accounts for the observed acceleration in cross-border asset trade among advanced economies in the early 1990s as it was mainly the industrial countries that switched to an inflation targeting regime at the time. The third chapter uses an open-economy neoclassical growth model to explain the saving and investment behavior of the U.S. and a group of other OECD countries. We find that while the model explains investment quite well, it tends to overpredict U.S saving and underpredict saving in the rest of the world. We show that the closed-economy version of the model also predicts saving accurately but that is only because it imposes equality between saving and investment. In effect, the model explains investment not saving behavior. / Arts, Faculty of / Vancouver School of Economics / Graduate

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This thesis contributes to the literature on the consumption-portfolio choice under uncertainty and is motivated by several empirical failures of the standard consumption-based capital asset pricing model (CCAPM). This canonical model has proven disappointing empirically and has even been questioned whether it is theoretically valuable and practically useful even if it is in some sense the only model we have. The frustration is due to that the model performs no better in practice and generates some well-known consumption puzzles and asset pricing puzzles. The purpose of the thesis is to reexamine these puzzles and then to resolve them. After the debate of Hansen and Singleton (1983) and Hall (1988), the estimates of the elasticity of intertemporal substitution (EIS) of consumption in a representative agent model have not resulted in any consensus. Based on this observation, the first chapter of this thesis is focused on resolving the elasticity puzzle or the unresponsiveness to interest rates. We propose a new theoretical and empirical perspective on the relationship between consumption growth and asset returns. In the spirit of Hansen and Singleton (1983), we demonstrate that observed growth rate of consumption responds not only to a specific asset return but also to other asset returns. Empirically, US postwar quarterly data are used to fit the regression model derived in the chapter, and the sample period is 1953Q2-2001Q2. Empirical results show that the EIS is greater than 0.1, the maximum value considered possible by Hall (1988). Accordingly, we argue that there is no elasticity puzzle in the standard representative agent model. The second chapter provides an explanation for the puzzle of excess sensitivity of consumption to expected income proposed by Flavin (1981). We exploit consumer's superior information (i.e., windfalls in investments and in income) to integrate the consumption Euler equations into a generalized Euler equation. The implications emerging from the equation can refute much of the empirical evidence against the permanent income hypothesis (PIH). In short, we conclude that consumption growth is sensitive to windfalls in income, but not to expected income. Thus, Friedman's prescient insight is being formally corroborated in standard utility theory. The equation also provides an alternative approach permitting one more precisely to estimate the preference parameters and much easier to identify the time-series properties of labor income. Empirical results based on U.S. postwar quarterly data show that the EIS is significantly positive and the labor income should follow a nonstationary second-order autoregressive process. The last chapter of the thesis, chapter three, attempts to address the equity premium puzzle, proposed by Mehra and Prescott (1985), and the risk-free rate puzzle, proposed by Weil (1989). These two asset pricing puzzles have troubled financial economists for nearly two decades. To date, there is still no convincing solution for the equity premium puzzle. The CCAPM is apparently inconsistent with the data, especially the annual data in the 1889-1978 period used by Mehra and Prescott (1985). This has led many economists to question whether the model should be abandoned. The purpose of the chapter is to resolve the two puzzles, and then to consolidate the Lucas-Breeden paradigm embedded in the standard CCAPM. We demonstrate that the equity premium puzzle is resulted from the gaps between the expected asset returns and the actual ones. These gaps have conventionally been regarded as regression disturbances, and explained as good luck or unexpected windfalls. We introduce an alternative way that, using other good luck to explain a given good luck, can help fill in the specific gap. Results of numerical calculations and parametric estimation show that, the gap has been significantly narrowed down and hence the equity premium and risk-free rate puzzles are successfully resolved.

This thesis studies the optimal conduct of unconventional monetary policy in the form of purchases of long-term government debt by the central bank and, motivated by this policy tool, the evolution of long-term government debt holdings in household portfolios over the course of the life cycle. It is comprised of three self-contained chapters. The first chapter investigates whether it can be beneficial for central banks to use the unconventional tool even when the main policy rate is not constrained by the zero lower bound. A friction in the interaction between households and banks allows central bank purchases of long-term government debt to reduce long-term interest rates and thus to stimulate economic activity. If debt purchases and conventional short-term interest rate policy are coordinated in an appropriate way, the central bank is able to reduce the volatility of output and inflation. In the second chapter, the role that unconventional monetary policy can play in a currency union is analysed. A model is laid out, in which two countries form a currency union with a common central bank but separate and uncoordinated fiscal policy institutions. When monetary policy is implemented only through the common short-term interest rate, the central bank is unable to respond effectively to country-specific shocks. Due to segmentation in the market for long-term government debt, the yield on long-term debt can differ across countries. As a result, a monetary policy authority that can rely on bond purchases is able to address idiosyncratic shocks reflected in volatility of the natural terms of trade more effectively and to achieve higher welfare than one that cannot make use of this instrument. The final chapter studies the long-term government bond share in household portfolios over the course of the life cycle. US data from the Survey of Consumer Finances suggests that participation in the market for long-term government debt first increases and later decreases as agents approach the retirement age. The portfolio share conditional on participation is non-decreasing over the working life. These stylised facts can be explained by means of a portfolio choice model in which agents are subject to aggregate risk through asset returns as well as idiosyncratic risk through labour income and the stochastic events of retirement and death.

We theoretically and empirically study portfolio optimization under transaction costs and establish a link between turnover penalization and covariance shrinkage with the penalization governed by transaction costs. We show how the ex ante incorporation of transaction costs shifts optimal portfolios towards regularized versions of efficient allocations. The regulatory effect of transaction costs is studied in an econometric setting incorporating parameter uncertainty and optimally combining predictive distributions resulting from high-frequency and low-frequency data. In an extensive empirical study, we illustrate that turnover penalization is more effective than commonly employed shrinkage methods and is crucial in order to construct empirically well-performing portfolios.

<p>I analyze a large number of investment decisions based on theories that have been developed and formalized over the past 50 years. Previous work in this field unveils a number of biases which affect ones choices when the outcome is uncertain. In my thesis I find evidence of these already known biases and focus on finding rational explanations for their existence. I also introduce two unexplored biases; the homeboy bias and the menu bias.</p><p>The results clearly indicate that sophisticated investors are generally less subject to these biases. Since pension schemes in many nations are shifting towards defined contribution schemes, investment decisions and risk preferences will be of great consequence to investors’ personal economy and ability to consume, affecting the economy in general. It is therefore of great importance that policy makers do all that they can to increase investors sophistication and create a playing field which facilitates economically sound investing.</p>

I analyze a large number of investment decisions based on theories that have been developed and formalized over the past 50 years. Previous work in this field unveils a number of biases which affect ones choices when the outcome is uncertain. In my thesis I find evidence of these already known biases and focus on finding rational explanations for their existence. I also introduce two unexplored biases; the homeboy bias and the menu bias. The results clearly indicate that sophisticated investors are generally less subject to these biases. Since pension schemes in many nations are shifting towards defined contribution schemes, investment decisions and risk preferences will be of great consequence to investors’ personal economy and ability to consume, affecting the economy in general. It is therefore of great importance that policy makers do all that they can to increase investors sophistication and create a playing field which facilitates economically sound investing.

<p>This dissertation consists of two essays in international macroeconomics. In the first essay I explore the role of portfolio diversification in explaining the distribution of foreign investment across countries. I do so by adopting a portfolio allocation approach to risk, that is widely used in empirical finance, to complement more traditional analyses of foreign capital flows across countries. I capture the portfolio diversification motive by a measure of country-specific riskiness, "covariance risk", which I construct as how countries' growth rates covary with the stochastic discount factor of a representative international investor. The idea is to capture the extent to which investments in a foreign economy provide a hedge against the investor's overall risk. My key new empirical finding is a strong and significant correlation between this new measure of country riskiness and foreign investment allocations. Less risky countries, i.e countries whose growth rates are more highly correlated with the investor's stochastic discount factor, receive larger investment shares than more risky countries. I interpret this result as evidence that investors do take into account diversification opportunities not only for portfolio investment decisions but also for foreign direct investment decisions. My empirical results confirm the theoretical predictions of standard portfolio allocation models.</p><p>In the second essay I explore the business cycle regularities of low-income countries in comparison to those observed in middle- and high-income countries. The data reveals several distinguishing features of the business cycle in low-income countries compared to the other two income groups: acyclical trade balances; highest volatility of consumption relative to output; highest volatility of debt; highest average debt-to-output ratio and lowest average savings ratio; significant negative correlation between domestic saving rates and the net foreign asset position. My main finding is that a small open economy model with both trend and transitory shocks to productivity, and varying intertemporal elasticity of substitution, motivated by subsistence consumption theories, can be used to account for the distinguishing features of the three income groups. The theoretical model shows that while both permanent shocks and transitory fluctuations around the trend are important sources of fluctuations in low-income countries, temporary shocks play a predominant role. In comparison to the other two income groups the volatility of the temporary shock for the low-income countries is more than three times higher than that for the high-income group and twice as large as that for the middle-income group. The same pattern holds for the permanent shock.</p> / Dissertation