The Journal of Finance

Uncertainty, Time‐Varying Fear, and Asset Prices

Published: 05/20/2013   |   DOI: 10.1111/jofi.12068

ITAMAR DRECHSLER

I construct an equilibrium model that captures salient properties of index option prices, equity returns, variance, and the risk‐free rate. A representative investor makes consumption and portfolio choice decisions that are robust to his uncertainty about the true economic model. He pays a large premium for index options because they hedge important model misspecification concerns, particularly concerning jump shocks to cash flow growth and volatility. A calibration shows that empirically consistent fundamentals and reasonable model uncertainty explain option prices and the variance premium. Time variation in uncertainty generates variance premium fluctuations, helping explain their power to predict stock returns.

Banking on Deposits: Maturity Transformation without Interest Rate Risk

Published: 02/15/2021   |   DOI: 10.1111/jofi.13013

ITAMAR DRECHSLER, ALEXI SAVOV, PHILIPP SCHNABL

We show that maturity transformation does not expose banks to interest rate risk—it hedges it. The reason is the deposit franchise, which allows banks to pay deposit rates that are low and insensitive to market interest rates. Hedging the deposit franchise requires banks to earn income that is also insensitive, that is, to lend long term at fixed rates. As predicted by this theory, we show that banks closely match the interest rate sensitivities of their interest income and expense, and that this insulates their equity from interest rate shocks. Our results explain why banks supply long‐term credit.

A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

Published: 08/11/2014   |   DOI: 10.1111/jofi.12206

VIRAL ACHARYA, ITAMAR DRECHSLER, PHILIPP SCHNABL

We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost increases sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government guarantees and bond holdings. Using credit default swap (CDS) rates on European sovereigns and banks, we show that bailouts triggered the rise of sovereign credit risk in 2008. We document that post‐bailout changes in sovereign CDS explain changes in bank CDS even after controlling for aggregate and bank‐level determinants of credit spreads, confirming the sovereign‐bank loop.

A Model of Monetary Policy and Risk Premia

Published: 06/22/2017   |   DOI: 10.1111/jofi.12539

ITAMAR DRECHSLER, ALEXI SAVOV, PHILIPP SCHNABL

We develop a dynamic asset pricing model in which monetary policy affects the risk premium component of the cost of capital. Risk‐tolerant agents (banks) borrow from risk‐averse agents (i.e., take deposits) to fund levered investments. Leverage exposes banks to funding risk, which they insure by holding liquidity buffers. By changing the nominal rate the central bank influences the liquidity premium, and hence the cost of taking leverage. Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices, volatility, investment, and growth. We analyze forward guidance, a “Greenspan put,” and the yield curve.

Who Borrows from the Lender of Last Resort?

Published: 05/23/2016   |   DOI: 10.1111/jofi.12421

ITAMAR DRECHSLER, THOMAS DRECHSEL, DAVID MARQUES‐IBANEZ, PHILIPP SCHNABL

We analyze lender of last resort (LOLR) lending during the European sovereign debt crisis. Using a novel data set on all central bank lending and collateral, we show that weakly capitalized banks took out more LOLR loans and used riskier collateral than strongly capitalized banks. We also find that weakly capitalized banks used LOLR loans to buy risky assets such as distressed sovereign debt. This resulted in a reallocation of risky assets from strongly to weakly capitalized banks. Our findings cannot be explained by classical LOLR theory. Rather, they point to risk taking by banks, both independently and with the encouragement of governments, and highlight the benefit of unifying LOLR lending and bank supervision.