Essays in Financial Economics

Abstract

This thesis contains three chapters exploring the interrelationships among risk premia, the valuation of government debt, and macroeconomic dynamics. The first chapter documents and explores the implications of the risk price puzzle–the empirical disconnect between inflation and risk premium shocks. I show that existing New Keynesian models struggle to rationalize the risk price puzzle with an upward-sloping Phillips curve. To resolve the puzzle, I develop a novel macro-finance model that integrates a two-sector real business cycle framework with the government debt valuation equation, which determines the price level without nominal rigidities. Empirically, the response of inflation to risk premium shocks switches from positive to negative around 1998, mirroring the change in the stock-bond correlation. The model attributes this phenomenon to the changing covariance between shocks to the risk premium and real risk-free rate, which is consistent with the heightened responsiveness of monetary policy to the stock market (“Fed put”).

The second chapter uses a flexible SDF model to infer the values of untraded tax and expenditure claims at the state level. Since state governments do not issue their own currencies, they are precluded from monetizing the value of their debt through inflation. On average, I find that surplus risk generates a gap between the market and fundamental values of state-level debt, although the gap is an order of magnitude smaller than at the federal level. Inconsistent with the prior literature, more stringent balanced budget amendments appear to have no effect on state fiscal capacity. The third chapter documents the impact of risk premium shocks on firm-level outcomes and explores the dimensions of heterogeneity in those responses. I find that investment falls more for firms with higher betas. Risk premium shocks also increase misallocation as proxied by dispersion in marginal product of capital (MPK), although they have no effect on aggregate total factor productivity.