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A model of financial asset price determination is proposed that incorporates flat trading features into an efficient price process. The model involves the superposition of a Brownian semimartingale process for the effcient price and a Bernoulli process that determines the extent of price trading. The approach is related to sticky price modeling and the Calvo pricing mechanism in macroeconomic dynamics. A limit theory for the conventional realized volatility (RV) measure of integrated volatility is developed. The results show that RV is still consistent but has an inflated asymptotic variance that depends on the probability of flat trading. Estimated quarticity is similarly affected, so that both the feasible central limit theorem and the inferential framework suggested in Barndorff-Nielson and Shephard (2002) remain valid under flat price trading even though there is information loss due to flat trading effects. The results are related to work by Jacod (1993) and Mykland and Zhang (2006) on realized volatility measures with random and intermittent sampling, and to ACD models for irregularly spaced transactions data. Extensions are given to include models with microstructure noise. Some simulation results are reported. Empirical evaluations with tick-by-tick data indicate that the effect of flat trading on the limit theory under microstructure noise is likely to be minor in most cases, thereby affirming the relevance of existing approaches.

We investigate if the benchmark transition from London Interbank Offered Rate (Libor) to Secured Overnight Financing Rate (SOFR) affects the costs of borrowing floating rate debt. The primary market for dollar-denominated floating rate notes (FRNs) provides an ideal laboratory to study these e ects. Comparing the spreads of FRNs linked to LIBOR and SOFR, issued by the same entity during the same month, we find a significantly lower yield spread for SOFR-linked debt after adjusting for the maturity-matched spreads from the swap market. In addition, despite identification challenges, we observe a quantitatively similar pattern in the syndicated loan market.

We consider a noisy rational expectations equilibrium in a multi-asset economy populated by informed and uninformed investors, and noise traders. We relax the usual assumption of normally distributed asset payoffs and allow for assets with very general payoff distributions, including non-redundant contingent claims, such as options and other derivatives. We provide necessary and sufficient conditions under which contingent claims provide information about the source of uncertainty in the economy and, hence, reduce the asymmetry of information. We show that introducing a volatility derivative makes incomplete-market economies effectively complete. We also apply our results to pricing risky debt and equity and demonstrate that firms cannot manipulate the information contained in debt and equity prices by changing the face value of debt. Our paper provides a new tractable framework for studying asset prices under asymmetric information. When the market is complete, we derive the equilibrium in closed form. When the market is incomplete, we derive it in terms of easily computable inverse functions.

Many financial instruments are designed with embedded leverage, such as options and leveraged exchange-traded funds (ETFs). Embedded leverage alleviates investors’ leverage constraints, and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find empirically that options and leveraged ETFs provide significant amounts of embedded leverage; this embedded leverage increases return volatility in proportion to the embedded leverage; and higher embedded leverage is associated with lower risk-adjusted returns. The results are statistically and economically significant, and we provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics. (JEL G02, G11, G12, G13, G14, G20)

We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with „deep‟ habits. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese-Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.

We provide the first comprehensive analysis of option information for pricing the cross-section of stock returns by jointly examining extensive sets of firm and option characteristics. Using portfolio sorts and high-dimensional methods, we show that certain option measures have significant predictive power, even after controlling for firm characteristics, earning a Fama-French three-factor alpha in excess of 20% per annum. Our analysis further reveals that the strongest option characteristics are associated with information about asset mispricing and future tail return realizations. Our findings are consistent with models of informed trading and limits to arbitrage.

This work uses financial markets connected by arbitrage relations to investigate the dynamics of price and liquidity discovery, which refer to the cross-instrument forecasting power for prices and liquidity, respectively. Specifically, we seek to understand the linkage between the cheapest to deliver bond and closest futures pairs by using high-frequency data on European governments obligations and derivatives. We split the 2019-2021 sample into three subperiods to appreciate changes in the liquidity discovery induced by the COVID-19 pandemic. Within a cointegration model, we find that price discovery occurs on the futures market, and document strong empirical support for liquidity spillovers both from the futures to the cash market as well as from the cash to the futures market.

This paper proposes a new test for simultaneous intraday jumps in a panel of high frequency financial data. We utilize intraday first-high-low-last values of asset prices to construct estimates for the cross-variation of returns in a large panel of high frequency financial data, and then employ these estimates to provide a first-high-low-last price based test statistic to detect common large discrete movements (co-jumps). We study the finite sample behavior of our first-high-low-last price based test using Monte Carlo simulation, and find that it is more powerful than the Bollerslev et al (2008) return-based co-jump test. When applied to a panel of high frequency data from the Chinese mainland stock market, our first-high-low-last price based test identifies more common jumps than the return-based test in this emerging market.

Modelling stock return generating process as a single factor model, we show analytically that the relation between idiosyncratic volatility measured as variance of the residuals and expected stock return in the cross-section may be represented by a parabola that opens to the left and has horizontal axis. This relation is uncovered for stocks of similar volatility and no abnormal return. The sensitivity of the derived relation when these restrictions are relaxed is discussed. Our findings, to a great extent, help uncover the shape of the non-linear inverse relation between idiosyncratic volatility and expected stock return observed in the cross-section in previous empirical studies.

The presence of different prices in different databases for the same securities can impair the comparability of research efforts and seriously damage the management decisions based upon such research. In this study we compare the six major sources of corporate Credit Default Swap prices: GFI, Fenics, Reuters EOD, CMA, Markit and JP Morgan, using the most liquid single name 5-year CDS of the components of the leading market indexes, iTraxx (European firms) and CDX (US firms) for the period from 2004 to 2010. We find systematic differences between the data sets implying that deviations from the common trend among prices in the different databases are not purely random but are explained by idiosyncratic factors as well as liquidity, global risk and other trading factors. The lower is the amount of transaction prices available the higher is the deviation among databases. Our results suggest that the CMA database quotes lead the price discovery process in comparison with the quotes provided by other databases. Several robustness tests confirm these results.

This paper studies whether and why algorithmic traders exhibit one of the most broadlydocumented behavioral puzzles – the disposition effect. We use trade data from the NASDAQ Copenhagen Stock Exchange merged with the weather data. We find that on average, the disposition effect for human traders is substantial and increases significantly on colder days, while for similarly-trading algorithms, it is insignificant and insensitive to the weather. This provides causal evidence of the link between human psychology and the disposition effect and suggests that algorithms can reduce psychology-related human errors. Considering the ongoing AI adoption, this may have broad implications.

In a parsimonious regime switching model, we find strong evidence that expected consumption growth varies over time. Adding inflation as a second variable, we uncover two states in which expected consumption growth is low, one with high and one with negative expected inflation. Embedded in a general equilibrium asset pricing model with learning, these dynamics replicate the observed time variation in stock return volatilities and stock- bond return correlations. They also provide an alternative derivation for a measure of time-varying disaster risk suggested by Wachter (2013), implying that both the disaster and the long-run risk paradigm can be extended towards explaining movements in the stock-bond correlation.

Cryptocurrencies provide a unique opportunity to identify how derivatives impact spot markets. They are fully fungible, trade across multiple spot exchanges at different prices, and futures contracts were selectively introduced on bitcoin (BTC) exchange rates against the USD in December 2017. Following the futures introduction, we find a significantly greater increase in cross-exchange price synchronicity for BTC--USD relative to other exchange rate pairs, as demonstrated by an increase in price correlations and a reduction in arbitrage opportunities and volatility. We also find support for an increase in price efficiency, market quality, and liquidity. The evidence suggests that futures contracts allowed investors to circumvent trading frictions associated with short sale constraints, arbitrage risk associated with block confirmation time, and market segmentation. Overall, our analysis supports the view that the introduction of BTC--USD futures was beneficial to the bitcoin spot market by making the underlying prices more informative.

In this paper, we examine the pricing determinants in the systemically important tri-party repo market. Taking advantage of the recently available N-MFP reports filed by money market funds, we construct a novel dataset that contains tri-party repo transactions between money market funds and dealer banks. We find a large cross-sectional heterogeneity in repo pricing, reflected most significantly in the haircuts of repos backed by equity and corporate bonds. Surprisingly, it is the fund families, not bank dealers, who are the dominant factor in determining the pricing. Moreover, the repo market exhibits significant segmentation, with fund families adopting three different pricing schemes: counter-party sensitive, counter-party and collateral sensitive, and uniform. Most fund families use uniform haircuts by fixing a constant haircut, which itself varies across families, for all repos within each asset class, regardless of the quality of collateral or counter-party. Investigating further on the lending/borrowing relationship between fund families and dealers, we find that, when faced with such a rich pricing pattern, dealers do not shop around for a better haircut and are inclined to maintain a stable relationship with their lenders. Finally, for repos backed by Treasury securities, there is little variation in both haircuts and spreads, regardless of the fund family.

Housing market transactions are a matter of public record and thus provide a rare opportunity to analyze the behavior, performance, and strategies of individual investors. Using data for all housing transactions in the Los Angeles area from 1988-2009, this paper provides empirical evidence on investor behavior that is consistent with several rationales for speculative investment in the finance literature, including the roles of middlemen and naïve speculators. Speculative activity by novice investors increased sharply in the recent housing boom. These investors earned little more than the market rate of appreciation and demonstrated no ability to foresee market price movements.

We present a model that simultaneously explains why uncovered interest parity holds for some pairs of countries and not for others. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The negative slope in the Fama regression arises when monetary instability is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary instability is high, the Fama slope is positive in line with uncovered interest parity. The model is simulated using the artificial economy methodology for 34 currencies against the US dollar. We conclude that, given the predominance of precautionary savings, the degree of monetary instability explains whether or not uncovered interest parity holds.

We introduce a canonical representation of call options, and propose a solution to two open problems in option pricing theory. The first problem was posed by (Kassouf, 1969, pg. 694) seeking “theoretical substantiation” for his robust option pricing power law which eschewed assumptions about risk attitudes, rejected risk neutrality, and made no assumptions about stock price distribution. The second problem was posed by (Scott, 1987, pp. 423-424) who could not find a unique solution to the call option price in his option pricing model with stochastic volatility–without appealing to an equilibrium asset pricing model by Hull and White (1987), and concluded: “[w]e cannot determine the price of a call option without knowing the price of another call on the same stock”. First, we show that under certain conditions derivative assets are superstructures of the underlying. Hence any option pricing or derivative pricing model in a given number field, based on an anticipating variable in an extended field, with coefficients in a subfield containing the underlying, is admissible for market timing. For the anticipating variable is an algebraic number that generates the subfield in which it is the root of an equation. Accordingly, any polynomial which satisfies those criteria is admissible for price discovery and or market timing. Therefore, at least for empirical purposes, elaborate models of mathematical physics or otherwise are unnecessary for pricing derivatives because much simpler adaptive polynomials in suitable algebraic numbers are functionally equivalent. Second, we prove, analytically, that Kassouf (1969) power law specification for option pricing is functionally equivalent to Black and Scholes (1973); Merton (1973) in an algebraic number field containing the underlying. In fact, we introduce a canonical polynomial representation theory of call option pricing convex in time to maturity, and algebraic number of the underlying–with coefficients based on observables in a subfield. Thus, paving the way for Wold decomposition of option prices, and subsequently laying a theoretical foundation for a GARCH option pricing model. Third, our canonical representation theory has an inherent regenerative multifactor decomposition of call option price that (1) induces a duality theorem for call option prices, and (2) permits estimation of risk factor exposure for Greeks by standard [polynomial] regression procedures. Thereby providing a theoretical (a) basis for option pricing of Greeks, and (b) solving Scott’s dual call option problem a fortiori with our duality theory in tandem with Riesz representation theory. Fourth, when the Wold decomposition procedure is applied we are able to construct an empirical pricing kernel for call option based on residuals from a model of risk exposure to persistent and transient risk factors. Keywords: number theory; price discovery; derivatives pricing; asset pricing; canonical representation; Wold decomposition; empirical pricing kernel; option Greeks; dual option pricing

We introduce a closed form behavioural stochastic Arrow-Pratt risk process, decomposed into discrete asymmetric risk seeking and risk averse components that run on different local times in ϵ-disks centered at risk free states. Additionally, we embed Arrow-Pratt (“AP”) risk measure in a simple dynamic system of discounted cash flows with constant volatility, and time varying drift. Signal extraction of Arrow-Pratt risk measure shows that it is highly nonlinear in constant volatility for cash flows. Robust identifying restrictions on the system solution confirm that even for small time periods constant volatility is not a measure of AP risk. By contrast, time-varying volatility measures aspects of embedded AP risk. Whereupon maximal AP risk measure is obtained from a convolution of input volatility and idiosyncratic shocks to the system. We provide four applications for our theory. First, we find that Engle, Ng and Rothschild (1990) Factor-ARCH model for risk premia is misspecified because the factor price of risk is time varying and unstable. Our theory predicts that a hyper-ARCH correction factor is required to remove the Factor-ARCH specification. Second, when applied to analysts beliefs about interest rates and volatility, we find that AP risk measure is a feedback control over stochastic cash flows. Whereupon increased risk aversion to negative shocks to earnings increases volatility. Third, we use an oft cited example of Benes, Shepp and Witsenhausen (1980) to characterize a controlled AP diffusion for a conservative investor who wants to minimize the AP risk process for an asset. Fourth, we recover stochastic differential utility functional from the AP risk process and show how it is functionally equivalent to Duffie and Epstein’s (1992) parametrization.

We provide theoretical and empirical arguments in favor of a diminishing marginal premium for market risk. In capital market equilibrium with binding portfolio restrictions, investors with different risk aversion levels generally hold different sets of risky securities. Whereas the traditional linear relation breaks down, equilibrium can be described or approximated by a concave relation between expected return and market beta, and a concave relationship between market alpha and market beta. An empirical analysis of U.S. stock market data confirms the existence of a significant concave cross-sectional relation between average return and estimated market beta. We estimate that the market risk premium is at least four to six percent per annum, substantially above traditional estimates. A practical implication for active portfolio managers is that the alpha of “betting against beta” strategies seems dominated by the medium-minus-high-beta spread rather than the low-minus-medium-beta spread. The success of such strategies thus largely depends on underweighting or short selling high-beta stocks.

This paper tests Uncovered Interest Rate Parity (UIP) using LIBOR rates for six major international currencies for the period January 2001 to December 2008. We find that UIP generally holds over a short-term (above 5-months) horizon for individual as well as groups of currencies. Our results suggest that it is important to consider the cross-correlation between currencies. We also find that “state dependence” plays an important role for currencies with a negative interest rate differential vis-à-vis the US dollar. This state dependence could also be instrumental in explaining exchange rate overshooting.

A single macroeconomic factor based on growth in the capital share of aggregate income exhibits significant explanatory power for expected returns across a range of equity characteristic portfolios and non-equity asset classes, with risk price estimates that are of the same sign and similar in magnitude. Positive exposure to capital share risk earns a positive risk premium, commensurate with recent asset pricing models in which redistributive shocks shift the share of income between capital owners, who finance consumption primarily out of asset ownership, and workers, who finance consumption primarily out of wages and salaries.

Using an equilibrium asset and option pricing model in a production economy under jump diffusion, we derive an analytical link between the equity premium, risk aversion and the systematic variance and skewness risk premium. In an empirical application of the model using more than 20 years of data on S&P500 index options, we find that, in line with theory, risk-averse investors demand risk-compensation for holding equity when the systematic skewness risk premium is high. However, when we differentiate between market conditions proxied by investor sentiment, we find that in up-markets (high sentiment) risk aversion is low, while in down-markets (low sentiment) risk aversion is high. We show that in line with theory, the skewness-risk-premium-return relationship only holds when risk aversion is high. In periods of low risk aversion, investors demand lower risk compensation, thus substantially weakening the skewness-risk premium-return trade off. Therefore, we also provide new evidence that helps to disentangle sentiment from risk aversion.

Heightened counterparty risk during the recent financial crisis has raised questions about the role clearinghouses play in global financial stability. Empirical identification of the effect of centralized clearing on counterparty risk is challenging because of the co-incidence of macro-economic turbulence and the introduction of clearinghouses. We overcome these concerns by examining a novel historical experiment, the establishment of a clearinghouse on the New York Stock Exchange (NYSE) in 1892. During this period the largest NYSE stocks were also listed on the Consolidated Stock Exchange (CSE), which already had a clearinghouse. Using identical securities on the CSE as a control, we find that the introduction of clearing reduced annualized volatility of NYSE returns by 90-173bps and increased asset values. Prior to clearing, shocks to overnight lending rates reduced the value of stocks on the NYSE, relative to identical stocks on the CSE, but this was no longer true after the establishment of clearing. We also show that at least ½ of the average reduction in counterparty risk on the NYSE is driven by a reduction in contagion risk - the risk of a cascade of broker defaults. Our results indicate that clearing can cause a significant improvement in market stability and value through a reduction in network contagion and counterparty risk.

The ability of corporations to raise external equity finance varies with macroeconomic conditions, suggesting that the cost of equity issuance is time-varying. Using cross sectional data on U.S. publicly traded firms, we construct an empirical proxy of an aggregate shock to the cost of equity issuance, which we interpret as a financial shock. We show that this shock captures systematic risk, and that exposure to this shock helps price the cross section of stock returns including book-to-market, investment, and size portfolios. We propose a dynamic investment-based model with stochastic equity issuance costs and a collateral constraint to interpret the empirical findings. Our central finding is that time variation in external equity financing costs is important for the model to quantitatively capture the joint dynamics of firms’ asset prices, real quantities, and financing flows. In the model, growth firms, high investment firms, and large firms, can substitute more easily debt financing for equity financing when it becomes more costly to raise external equity, hence these firms are less risky in equilibrium. The model also replicates the failure of the unconditional CAPM in pricing the cross section of stock returns.

We show that, in a frictionless and efficient market, an asset pricing model that better describes investors' behavior should better forecast stock index returns. We propose a dividend model that predicts, out-of-sample, 31.3% of the variation in annual dividend growth rates (1976-2015). Further, when learning about dividend dynamics is incorporated into a long-run risks model, the model predicts, out-of-sample, 22.4% of the variation in annual stock index returns (1976-2015). This supports the view that both investors' aversion to long-run risks and learning about these risks are important in determining asset prices and expected returns.

We ask whether a pay-as-you-go financed social security system is welfare improving in an economy with idiosyncratic productivity and aggregate business cycle risk. We show analytically that the whole welfare benefit from joint insurance against both risks is greater than the sum of benefits from insurance against the isolated risk components. One reason is the convexity of the welfare gain in total risk. The other reason is a direct risk interaction which amplifies the utility losses from consumption risk. We proceed with a quantitative evaluation of social security’s welfare effects. We find that introducing an unconditional minimum pension leads to substantial welfare gains in expectation, even net of the welfare losses from crowding out. About 60% of the welfare gains would be missing when simply summing up the isolated benefits.

Dealers in over-the-counter securities form networks to mitigate search frictions. The audit trail for municipal bonds shows the dealer network has a core-periphery structure. Central dealers are more efficient at matching buyers and sellers than peripheral dealers, which shortens intermediation chains and speeds up trading. Investors face a tradeoff between execution speed and cost. Central dealers provide immediacy by pre-arranging fewer trades and holding larger inventory. However, trading costs increase strongly with dealer centrality. Investors with strong liquidity need trade with central dealers and at times of market-wide illiquidity. Central dealers thus serve as liquidity providers of last resort.

Information on the performance of equities during the latter part of the globalized long nineteenth century is scarce, particularly for smaller European economies such as Ireland. Using a dataset of over 35,000 price-year observations from the Investor's Monthly Manual, this paper constructs new monthly Irish stock market price indices for the period 1864-1930, encompassing periods of significant economic and political turmoil in Irish history. In addition to a total market index covering all 118 equity securities issued by 94 companies, sector-specific indices are presented for railways, financial services companies, and miscellaneous industrial and retail companies. Weighted by market capitalization, nominal equity prices were largely static in the 1860s, before increasing by almost 60% in nominal terms between 1870 and 1878. Between 1878 and 1879, equity prices fell by one sixth in the space of a year, after which there was a secular rise in equity prices for two decades, with equity prices in 1899 twice what they had been in 1864. Between the turn of the century and the outbreak of the Great War, though, prices fell by 25%, a pattern that stands in stark contrast to returns on the London exchange, which were greater during 1894-1913 than during the preceding two decades. The period from 1914 until 1929 saw a number of boom-bust cycles, concurrent with war and other political events affecting Ireland, including its independence movement. Railway equities, which had trebled between the mid-1860s and the turn of the century, fell sharply during the 1910s and 1920s. In contrast, financial equity prices - which were just 20% higher in 1920 than in 1864 - rose strongly during the 1920s. Overall, the average annual gain in equity prices over the period was just 0.9%, well below levels associated with an equity premium puzzle.

Using the pandemic as a laboratory, we show that asset markets assign a time- varying price to firms' disaster risk exposure. In 2020 the cross-section of realized and expected stock returns reflected firms' different exposure to the pandemic, as measured by their vulnerability to social distancing. Realized and expected return differentials initially widened and then narrowed, but disaster exposure still commanded a risk premium in December 2020. When inferred from market outcomes, resilience correlates not only with social distancing, but also with cash and environmental ratings. However, vulnerability to social distancing is the only characteristic that identifies persistently scarred firms.

Retail investors pay over twice as much attention to local companies than non-local ones, based on Google searches. News volume and volatility amplify this attention gap. Attention appears causally related to perceived proximity: first, acquisition by a nonlocal company is associated with less attention by locals, and more by nonlocals close to the acquirer; second, COVID-19 travel restrictions correlate with a drop in relative attention to nonlocal companies, especially in locations with fewer flights after the outbreak. Finally, local attention predicts volatility, bid-ask spreads and nonlocal attention, not viceversa. These findings are consistent with local investors having an information-processing advantage.

We consider whether traders are more likely to commit securities violations when trading at home, a new form of working induced by the Covid pandemic. We examine data pre- and post-Covid, during which some traders were unexpectedly forced to work at home. The data indicate the presence of both a treatment and a selection effect, where work at home exhibits fewer misconduct cases. Work at home is associated with fewer cases of trading misconduct, although no difference in communications misconduct. The economic significance of working from home on trading misconduct is large for both the treatment and selection effects.

We define a sentiment indicator that exploits two contrasting views of return predictability, and study its properties. The indicator, which is based on option prices, valuation ratios and interest rates, was unusually high during the late 1990s, reflecting dividend growth expectations that in our view were unreasonably optimistic. We interpret it as helping to reveal irrational beliefs about fundamentals. We show that our measure is a leading indicator of detrended volume, and of various other measures associated with financial fragility. We also make two methodological contributions. First, we derive a new valuation-ratio decomposition that is related to the Campbell and Shiller (1988) loglinearization, but which resembles the traditional Gordon growth model more closely and has certain other advantages for our purposes. Second, we introduce a volatility index that provides a lower bound on the market's expected log return.

Managed portfolios that exploit positive first-order autocorrelation in monthly excess returns of equity factor portfolios produce large alphas and gains in Sharpe ratios. We document this finding for factor portfolios formed on the broad market, size, value, momentum, investment, prof- itability, and volatility. The value-added induced by factor management via short-term momentum is a robust empirical phenomenon that survives transaction costs and carries over to multi-factor portfolios. The novel strategy established in this work compares favorably to well-known timing strategies that employ e.g. factor volatility or factor valuation. For the majority of factors, our strategies appear successful especially in recessions and times of crisis.

We exploit a modification to Sustainalytics' environmental, social, and governance (ESG) rating methodology, which is subsequently adopted by Morningstar, to study whether ESG ratings are salient for stock pricing. We show that the inversion of the rating scale but not new information leads some investors to make incorrect assessments about the meaning of the change in ESG ratings. They buy (sell) stocks they misconceive as ESG upgraded (downgraded) even when the opposite is true. This trading behavior exerts transitory price pressure on a↵ected stocks. Our paper highlights the importance of ESG ratings for investors and consequently for asset prices. September 23, 2021

We identify a component of monetary policy news that is extracted from high-frequency changes in risky asset prices. These surprises, which we call “risk shifts”, are uncorrelated, and therefore complementary, to risk-free rate surprises. We show that (i) risk shifts capture the lion’s share of stock price movements around FOMC announcements; (ii) that they are accompanied by significant investor fund flows, suggesting that investors react heterogeneously to monetary policy news; and (iii) that price pressure amplifies the stock market response to monetary policy news. Our results imply that central bank information effects are overshadowed by short-term dynamics stemming from investor rebalancing activities and are likely to be more difficult to identify than previously thought.

Conditional yield skewness is an important summary statistic of the state of the economy. It exhibits pronounced variation over the business cycle and with the stance of monetary policy, and a tight relationship with the slope of the yield curve. Most importantly, variation in yield skewness has substantial forecasting power for future bond excess returns, high-frequency interest rate changes around FOMC announcements, and consensus survey forecast errors for the ten-year Treasury yield. The COVID pandemic did not disrupt these relations: historically high skewness correctly anticipated the run-up in long-term Treasury yields starting in late 2020. The connection between skewness, survey forecast errors, excess returns, and departures of yields from normality is consistent with a theoretical framework where one of the agents has biased beliefs.

As part of the Next Generation EU (NGEU) program, the European Commission has pledged to issue up to EUR 250 billion of the NGEU bonds as green bonds, in order to confirm their commitment to sustainable finance and to support the transition towards a greener Europe. Thereby, the EU is not only entering the green bond market, but also set to become one of the biggest green bond issuers. Consequently, financial market participants are eager to know what to expect from the EU as a new green bond issuer and whether a negative green bond premium, a so-called Greenium, can be expected for the NGEU green bonds. This research paper formulates an expectation in regards to a potential Greenium for the NGEU green bonds, by conducting an interview with 15 sustainable finance experts and analyzing the public green bond market from September 2014 until June 2021, with respect to a potential green bond premium and its underlying drivers. The regression results confirm the existence of a significant Greenium (-0.7 bps) in the public green bond market and that the Greenium increases for supranational issuers with AAA rating, such as the EU. Moreover, the green bond premium is influenced by issuer sector and credit rating, but issue size and modified duration have no significant effect. Overall, the evaluated expert interviews and regression analysis lead to an expected Greenium for the NGEU green bonds of up to -4 bps, with the potential to further increase in the secondary market.

This paper analyses the real economy effects of firms having some shareholders with a short investment horizon on their shareholder register. Short-term shareholders cause management to be concerned with the path of the share price as well as its ultimate value. Such shareholders in an economy lead to bubbles in the prices of key inputs, to the misallocation of firms to risky business models, and to increased costs of capital. For individual firms short-term shareholders induce the Board to reduce deferred incentives in CEO pay prompting CEO myopia and reduced investments in the long-run capabilities of the firm.

Functional Signal plus Noise (FSN) models are proposed for analysing the dynamics of a large cross-section of yields or asset prices in which contemporaneous observations are functionally related. The FSN models are used to forecast high dimensional yield curves for US Treasury bonds at the one month ahead horizon. The models achieve large reductions in mean square forecast errors relative to a random walk for yields and readily dominate both the Diebold and Li (2006) and random walk forecasts across all maturities studied. We show that the Expectations Theory (ET) of the term structure completely determines the conditional mean of any zero-coupon yield curve. This enables a novel evaluation of the ET in which its 1-step ahead forecasts are compared with those of rival methods such as the FSN models, with the results strongly supporting the growing body of empirical evidence against the ET. Yield spreads do provide important information for forecasting the yield curve, especially in the case of shorter maturities, but not in the manner prescribed by the Expectations Theory.

This paper proposes that all new euro area sovereign borrowing be in the form of jointly guaranteed eurobonds. To avoid classic moral hazard problems and to insure the guarantors against default, each country would pay a risk premium conditional on economic fundamentals to a joint debt management agency. This suggests that these bonds be called ‘euro-insurance bonds’. While the sovereign debt markets have taken increasing account of the economic fundamentals, the signal-to-noise ratio has been weakened by huge market volatility, so undercutting incentives for appropriate reforms and obscuring economic realities for voters. This paper uses an econometric model to show that competitiveness, public and private debt to GDP, and the fall-out from housing market crises are the most relevant economic fundamentals. Formula-based risk spreads based on these fundamentals would provide clear incentives for governments to be more oriented towards economic reforms to promote long-run growth than mere fiscal contraction. Putting more weight on incentives that come from risk spreads, than on fiscal centralization and the associated heavy bureaucratic procedures, would promote the principle of subsidiarity to which member states subscribe. The paper compares euro-insurance bonds incorporating these risk spreads with other policy proposals. Copyright 2013, Oxford University Press.

This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price., https://ia801504.us.archive.org/8/items/pricingConvertibleBondJumpDiffusion-5/pricingConvertibleBondJumpDiffusion-5.pdf

This article presents a comprehensive framework for valuing financial instruments subject to credit risk. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats in financial markets. We analyze how swap rates are affected by bilateral counterparty credit risk, and how CDS spreads depend on the trilateral credit risk of the buyer, seller, and reference entity in a contract. Moreover, we study the effect of collateralization on valuation, since the majority of OTC derivatives are collateralized. The model shows that a fully collateralized swap is risk-free, whereas a fully collateralized CDS is not equivalent to a risk-free one. Supplemental material at https://www.researchgate.net/profile/Tim_Xiao/publication/337157228_The_Impact_of_Default_Dependency_and_Collateralization_on_Asset_Pricing_and_Credit_Risk_Modeling/links/5ef0a4fc299bf1faac6cada3/The-Impact-of-Default-Dependency-and-Collateralization-on-Asset-Pricing-and-Credit-Risk-Modeling.pdf, https:://ia801501.us.archive.org/12/items/default-dependency-collateralization-7/default-dependency-collateralization-7.pdf

We study how allowing agents to use debt as collateral affects asset prices, leverage, and interest rates in a general equilibrium, heterogeneous-agent model with collateralized financial contracts and multiple states of uncertainty. In the absence of debt collateralization, multiple contracts are traded in equilibrium, with some agents borrowing using risky debt and others borrowing with risk-free debt. When agents can use debt contracts as collateral to borrow from other agents, margin requirements decrease, asset prices increase, and the interest rate on risky debt decreases. We characterize equilibrium for N states and L levels of debt collateralization and prove that enough levels of debt collateralization creates an equilibrium featuring maximal leverage on all debt contracts. In the dynamic model, debt collateralization creates larger asset price volatility.

Using only daily data on bond and stock returns, we identify and characterize flight to safety (FTS) episodes for 23 countries. On average, FTS days comprise less than 3% of the sample, and bond returns exceed equity returns by 2.5 to 4%. The majority of FTS events are country-specific not global. FTS episodes coincide with increases in the VIX and the Ted spread, decreases in consumer sentiment indicators and appreciations of the Yen, Swiss franc, and US dollar. The financial, basic materials and industrial industries under-perform in FTS episodes, but the telecom industry outperforms. Money market instruments, corporate bonds, and commodity prices (with the exception of metals, including gold) face abnormal negative returns in FTS episodes. Hedge funds, especially those belonging to the event-driven styles, display negative FTS betas, after controlling for standard risk factors. Liquidity deteriorates on FTS days both in the bond and equity markets. Both economic growth and inflation decline right after and up to a year following a FTS spell.

We study how the Eurosystem Collateral Framework for corporate bonds helps the European Central Bank (ECB) fulfill its policy mandate. Using the ECBs eligibility list, we identify the first inclusion date of both bonds and issuers. We find that due to the increased supply and demand for pledgeable collateral following eligibility, (i) securities lending market trading activity increases, (ii) eligible bonds have lower yields, and (iii) the liquidity of newly-issued bonds declines, whereas the liquidity of older bonds is una↵ected/improves. Corporate bond lending relaxes the constraint of limited collateral supply, thereby making the market more cohesive and complete. Following eligibility, bond-issuing firms reduce bank debt and expand corporate bond issuance, thus increasing overall debt size and extending maturity.

Equity basket correlation is an important risk factor. It characterizes the strength of linear dependence between assets and thus measures the degree of portfolio diversification. It can be estimated both under the physical measure from return series, and under the risk neutral measure from option prices. The difference between the two estimates motivates a so called "dispersion strategy". We study the performance of this strategy on the German market over the recent 2 years and propose several hedging schemes based on implied correlation (IC) forecasts. Modeling IC is a challenging task both in terms of computational burden and estimation error. First the number of correlation coefficients to be estimated would grow with the size of the basket. Second, since the IC is implied from option prices it is not constant over maturities and strikes. Finally, the IC changes over time. The dimensionality of the problem is reduced by an assumption that the correlation between all pairs of equities is constant (equicorrelation). The IC surface (ICS) is then approximated from implied volatilities of stocks and implied volatility of the basket. To analyze this structure and the dynamics of the ICS we employ a dynamic semiparametric factor model (DSFM).

We introduce Implied Volatility Duration (IVD) as a new measure for the timing of uncertainty resolution, with a high IVD corresponding to late resolution. Portfolio sorts on a large cross-section of stocks indicate that investors demand on average more than five percent return per year as a compensation for a late resolution of uncertainty. In a general equilibrium model, we show that 'late' stocks can only have higher expected returns than 'early' stocks, if the investor exhibits a preference for early resolution of uncertainty. Our empirical analysis thus provides a purely market-based assessment of the timing preferences of the marginal investor.

Many modern macro finance models imply that excess returns on arbitrary assets are predictable via the price-dividend ratio and the variance risk premium of the aggregate stock market. We propose a simple empirical test for the ability of such a model to explain the cross-section of expected returns by sorting stocks based on the sensitivity of expected returns to these quantities. Models with only one uncertainty-related state variable, like the habit model or the long-run risks model, cannot pass this test. However, even extensions with more state variables mostly fail. We derive conditions under which models would be able to produce expected return patterns in line with the data and discuss various examples.

This paper investigates the interdependence between the risk-pooling activity of the financial sector and: output, consumption, risk-free rate, and Sharpe ratio in a dynamic general equilibrium model of a productive economy. Due to their exposure to idiosyncratic shocks and market segmentation, heterogeneous households/entrepreneurs (h/entrepreneurs) are willing to mitigate their risk through a financial sector. The financial sector pools risky claims issued by different firms within its assets, faces an associated intermediation cost and, via leverage, provides a risk-free asset to h/entrepreneurs. Exogenous systematic shocks change the relative size of the financial sector, and thus the equilibrium amount of pooled risk, making financial leverage state-dependent and counter-cyclical. We study how this mechanism endogenously channels amplification of consumption and mitigation of output fluctuations. In equilibrium, financial sector leverage also determines counter-cyclical Sharpe ratios and pro-cyclical risk-free interest rates. Last, we investigate the relationship between the size of the financial sector, leverage, and welfare. We show that limiting financial sector leverage determines a sub-optimal pooling of idiosyncratic risk but fosters the growth rate of the h/entrepreneurs’ consumption. On the other side, when the financial sector is too large, it destroys too many resources after intermediation costs. Therefore, the h/entrepreneurs benefit the most when the financial sector is neither too small nor too big.

We show that FED policy announcements lead to a significant increase in international comovements in the cross-section of equity and in particular sovereign CDS markets. The relaxation of unconventionary monetary policies is felt strongly by emerging markets, and by countries that are open to the trading of goods and flows, even in the presence of floating exchange rates. It also impacts closed economies whose currencies are pegged to the dollar. This evidence is consistent with recent theories of a global financial cycle and the pricing of a FED’s put. In contrast, ECB announcements hardly affect comovements, even in the Eurozone.