How Income Risks Affect Financial Markets - An Empirical Analysis of Three Transmission Channels

Abstract

This thesis analyzes how financial markets are affected by income risk and unemployment. I focus on two sectors of financial markets and evaluate three potential transmission channels. To model how asset returns are affected by individual income risk, two possible approaches are developed and a third one examines how government bond yields are affected by aggregate income risk in the form of unemployment changes. The first and more traditional approach models individual income risk as a factor in a linear asset pricing model. With this model I examine how income risk influences the willingness of investors to take risks and the premium different types of portfolios have to pay in order to compensate for the portfolio's co-movement with the risk factor. The second approach considers psychological biases that influence how investors perceive income changes. Specifically, I test for the presence of behavioral effects that may arise from the exposure to individual income risk. A third study shifts the focus to a macroeconomic level. Here the relationship between government bond yields and unemployment is analyzed in a high-frequency heterogeneous vector-autoregression.