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We investigate the determinants of international stock market co-movements, shedding light on the relevance of politics-related factors. We propose a new characterization for the link connecting politics and financial markets, disentangling two different components: political risk and economic policy risk. We uncover the surprisingly low correlation between the two variables, and show they are priced differently by the market. We implement a pairs trading strategy, in the spirit of Gatev et al. (2006), which loads on international stock market co-movements. Exclusively relying on hard macro-data proves not to be sufficient to explain the statistically significant and economically large returns generated by the strategy. We show how to increase the abnormal returns (alphas) generated by the strategy by exploiting shorter-time co-movements. We document the utmost relevance of political risk, which explains and predicts returns driven by both short-term and long-run correlations. Our analysis also unveils the relevance of confidence factors, especially foreign investors' confidence, which should therefore be accounted for when assessing the co-variation of international stock market prices. more...

We construct a bivariate factor of political stability and economic policy confidence and show that it commands a significant premium of up to 15% per annum, in the global, developed, and emerging markets, robust to ICAPM, Fama-French five-factor model, Carhart, and ICAPM Redux. We propose an international capital asset pricing model incorporating the political factor, and test global and local estimations in developed and emerging economies. The model explains up to 77% of cross-sectional returns, has good predictive power, in several tests it performs better than the benchmark models in pricing equity indices and explains up to an incremental 25% of cross-sectional returns and is robust out of sample. more...

We introduce a new housing consumption-based asset pricing model (Housing CCAPM) that incorporates rare disaster events into the dynamics of non-housing consumption and rare boom/disaster events into housing consumption. Our analytical framework hinges on two key ideas. First, we extend existing Cumulant Generating Function-based pricing formulas to a two-good economy. Second, we develop an exponential affine approximation for the price-dividend ratio. These techniques enable us to derive intuitive closed form solutions for the risk-free rate, risk premia, the volatility of excess returns and the term structure of interest rates. Using monthly U.S. aggregate consumption data and a maximum likelihood estimation approach, we show that, while rare disaster events in non-housing consumption contribute only marginally to explaining the low risk-free rate, the high equity premium and high equity volatility observed in the data, rare boom/disaster events in housing expenditures solve these puzzles for moderate levels of risk aversion and intratemporal elasticity of substitution. Additionally, we show that the Housing CCAPM framework with CRRA utility will consistently produce theoretical upward-sloping real yield curves, and interpret the standard CCAPM risk-free rate as the rate that would prevail during extreme recessions. more...

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed-form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in-depth analysis of probabilities of default and the term structure of credit spreads. more...

We solve for the equilibrium of a stochastic neo-classical continuous time model without and with money under model ambiguity. We show that: (i) the correction for ambiguity stemming from the money supply is nil at equilibrium; (ii) money is neutral with respect to the stock market equilibrium (the equity risk premium); (iii) money is not neutral with respect to consumption and capital accumulation, and its effect may be quantitatively substantial; (iv) the preference for model robustness affects all the real economic variables as well as the expected inflation rate and the nominal interest rate. more...

We generalize the monetary economy with cash and credit goods pioneered by Lucas and Stokey (1983, 1987) to the case of a neoclassical production economy. Assuming a fairly general continuous time stochastic process for real capital returns, we show that money non-neutrality is generic, even though the money growth rate is i.i.d. and the representative agent’s utility is log separable. We also show that the capital to wealth ratio plays a key role in the transmission mechanism by which monetary policy affects the dynamics of all real variables, in particular those of the pricing kernel and of asset excess returns. We finally provide some empirical evidence that supports the hypothesized influence of the capital to wealth ratio on the US equity market premium. more...

Introducing uncertainty in the Reis's [Reis, R., 2007, The analytics of monetary non-neutrality in the Sidrauski model, Economics Letters 94 (1), 129–135] version of the Sidrauski model leads to a monetary policy that is not super-neutral even though money and consumption are separable in the utility function. This is because the real interest rate is affected by such a policy. Only in the case of an interest rate inelastic money demand does the super-neutrality result survive. more...

We examine the issue of pricing forward futures and option contracts written on the Consumer Price Index (CPI), the change of which is a measure of inflation affecting the economy. Traditional approaches postulate an exogenous process for the price level and then derive CPI derivatives prices by standard arbitrage arguments. By contrast, we build the general equilibrium of a continuous time monetary economy that is affected by both real and nominal shocks. The price level and thus the inflation rate are found endogenously and solutions for the prices of CPI derivatives are obtained, which are in closed form in a specialized version of the economy. more...

We derive the general equilibrium short-term real and nominal interest rates in a monetary economy affected by technological and monetary shocks and where the price level dynamics is endogenous. Assuming fairly general processes for technology and money supply, we show that an inherent feature of our equilibrium is that any real variable dynamics, in particular that of the short-term real interest rate, is driven by both monetary and real factors. This money non-neutrality is generic, as it does not stem from any friction such as price stickiness, or from a particular utility function. Non-neutrality obtains because the ex ante cost of real money holdings is random due to inflation uncertainty. We then analyze in depth a specialized version of this economy in which the state variables follow square root processes, and the representative investor has a log separable utility function. The short-term nominal rate dynamics we obtain encompasses most of the dynamics present in the literature, from Vasicek and CIR to recent quadratic and, more generally, non-linear interest rate models. Moreover, our results pave the way to several new nominal term structures. more...

We consider an international economy where the purchasing power parity (PPP) is violated and financial asset returns and exchange rates follow, in real terms, general diffusion processes driven by K state variables. A country-specific representative individual trades on available assets to maximize the expected utility of her final consumption. Her optimal strategy is shown to contain, in addition to the usual speculative component, only two hedging components, however large is K. The first one is associated with domestic interest rate risk and the second one with the risk brought about by the co-movements of the interest rates and the market prices of risk. The implementation of the strategy thus is much easier than with the traditional Merton decomposition, as it involves estimating the characteristics of the yield curve and the market prices of risk only, rather than those of numerous (and a priori unknown) state variables. In view of the necessity for optimizing agents to account for the (partial) asset return predictability that derives from the investors’ hedging demands at equilibrium, our result significantly lessens the difficulty of achieving the optimal portfolio strategy. The second hedging term turns out to depend on interest rate differentials across countries and to encompass hedging against PPP deviations. Therefore, in contrast with previous models that obtained a (direct) currency risk hedging component in a rather ad hoc manner, our decomposition leads to optimal (indirect) currency risk hedging in a natural and general way. It also provides new insights as to the pricing of foreign exchange risk at equilibrium. more...

We derive the general equilibrium of a dynamic financial market in which the investors' opportunity set includes nonredundant forward contracts. We show that Breeden's (1979) consumption-based CAPM equation for forward contracts contains an extra term relative to that for cash assets. We name this term a strategy risk premium. It compensates investors for the (systematic) risk that stems from their very portfolio strategies when the latter involve nonredundant forward contracts. We also show that Merton's (1973) multibeta intertemporal CAPM must be amended for forward contracts to exhibit adjusted risk premia for the market portfolio and all relevant state variables, as opposed to the usual risk premia for cash assets. Our results are shown not to depend on the usual cash-and-carry relationship, which, in general, does not hold. We, nevertheless, provide a well-known special case where it does hold, albeit not grounded on the usual no-arbitrage argument. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:817–840, 2003 more...

In an incomplete market in which non-redundant forward contracts contribute to span the uncertainty, some standard results of portfolio theory must be amended. When the investment opportunity set is driven by K state variables, a ( K +3)-mutual fund separation theorem is obtained in lieu of Merton's ( K +2)-fund separation result. The additional fund is a portfolio that hedges the interest rate risk brought about by the optimal portfolio strategy itself. Second, the mean-variance efficiency of the market portfolio of cash assets is neither a necessary nor a sufficient condition for the linear relationship between expected return and beta to hold. Third, the pricing equation for a forward contract is shown to contain an extra term relative to that for a cash asset, term we name strategy risk premium. more...

This paper investigates the optimal hedging strategy of a domestic expected utility maximizer endowed with a temporarily non-traded position in a foreign investment. The domestic and foreign yield curves, the exchange rate between the two involved currencies, and the foreign investment value are stochastic and obey fairly general diffusion processes. We compare the hedger's optimal strategies using either exchange rate forward contracts or futures contracts. For both strategies, the optimal number of contracts held can be broken down into several components having clear economic interpretations. However, while futures contracts are known in such a context to be more difficult to price than their forward counterparts, the optimal strategy using them is simpler. This is due to the fact that, when forward contracts are used, incurred profits or losses that accrue to the investor's wealth at each instant are locked-in in the forward position up to the contract maturity. Thus discounting these gains or losses back at the current date brings about an interest rate risk. Therefore the investor's hedging strategy itself generates an additional risk, which in turn induces the need for additional hedging. The magnitude of the difference between the two hedge ratios may be significant under a set of plausible assumptions. Since in general financial markets are not complete, the additional interest rate risk cannot be perfectly hedged. Hence the marking-to-market mechanism that characterizes futures contracts and allows for the complete elimination of this risk is valuable for risk averse agents. more...

In this article, the authors develop an arbitrage approach to valuing insurance‐linked securities (ILS) for non‐catastrophic events within a framework of stochastic interest rates. The prices of these transactions are driven by both an interest rate process and a non‐trivial actuarial risk process. The authors find that the duration of ILS is, in most cases, higher than the Macaulay duration of risk‐free bonds, which implies that the alleged relative out‐performance of ILS is illusory. more...

In an economy where interest rates and stock price changes follow fairly general stochastic processes, we analyze the portfolio problem of an investor endowed with a non-traded cash bond position. He can trade on stocks, the riskless asset and a futures contract written on the bond so as to maximize the expected utility of his terminal wealth. When the investment opportunity set is driven by an arbitrary number of state variables, the optimal portfolio strategy is known to contain a pure, preference free, hedge component, a speculative element and Merton–Breeden hedging terms against the fluctuations of each and every state variable. While the first two components are well identified and easy to work out, the implementation of the last ones is problematic as the investor must identify all the relevant state variables and estimate their distribution characteristics. Using the martingale approach, we show that the optimal strategy can be simplified to include, in addition to the pure hedge and speculative components, only two Merton–Breeden-type hedging elements, however large is the number of state variables. The first one is associated with interest rate risk and the second one with the risk brought about by the co-movements of the spot interest rate and the market prices of risk. The implementation of the optimal strategy is thus much easier, as it involves estimating the characteristics of the yield curve and the market prices of risk only rather than those of numerous (a priori unknown) state variables. Moreover, the investor's horizon is shown explicitly to play a crucial role in the optimal strategy design, in sharp contrast with the traditional decomposition. Finally, the role of interest rate risk in actual portfolio risk management is emphasized. more...