Friday, May 18, 2007

SSRN-A Unified Theory of Ten Financial Puzzles by Xavier Gabaix

Just found this while reading through papers for the upcoming Texas Finance Festival and found this by Gabaix (he of larger firms = more CEO pay fame). His new paper is really interesting, a tad challenging, and nothing if not ambitious!

In it this important paper potentially explains "a host of puzzles." How big is a host? About 10 accoring to the paper.

A portion of the abstract:
SSRN-A Unified Theory of Ten Financial Puzzles by Xavier Gabaix: "This paper [offers] a unified explanation for a host of puzzles about stocks, bonds and exchange rates. It builds on the Barro-Rietz view, that risk premia come from the probability of macroeconomic crises or disasters, and adds a variable intensity of disaster that can be asset-specific. Agents have stochastic assessments (which can be rational or behavioral) about the fundamental value that their assets would have if a disaster occurred. The model appears to explain...puzzles on stocks, bonds and exchange rates"

So what puzzles? Pretty much everything that is tied to risk and return differences. For instance:
"(i) equity premium puzzle...(iii) excess volatility puzzle (the fact that equity prices are so volatile) (iv) value-growth puzzle (stocks with high price-dividend ratios have abnormally low future future) (v) upward sloping nominal yield curve...(vii) corporate bond spread puzzle (the spread between corporate and government bond rates are higher than warranted by the U.S. historical experience)...."
As the author states the work is preliminary (some minor typos etc), but don't let that stop you, it has the potential to be HUGE!!! Which makes it I^3 on potential alone!

Gabaix, Xavier, "A Unified Theory of Ten Financial Puzzles" (January 31, 2006). Available at SSRN:

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