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Working Paper
Fluctuating confidence and stock-market returns
The drift of two different diffusion processes (asset returns) is determined by a state variable which can take on two values. It jumps between the two according to Poisson increments (this is called a 'regime-switch'). For any given position of the state variable the drift of one process is high and the other is low. I find that the posterior probability that the 1st asset has higher average returns, conditional on observing the path (returns) of each process, follows a diffusion process and calculate its infinitesimal parameters. I also derive analytical expressions for its stationary ...
Working Paper
Pricing the strategic value of poison put bonds
In times of low liquidity for a firm, poison put bondholders can threaten to either force the company into a reorganization or to raise its borrowing costs. A multilateral bargaining solution for the strategic value is formulated at the time of exercise. Even infinitesimal bondholders, putting non-cooperatively, are able to extract more than the intrinsic value whenever the amount of putable debt exceeds the firm's effective liquidity. Prior to the crisis all financial assets are priced in a continuous-time framework when interest rates follow the Vasicek process and firm's debtholders are ...
Conference Paper
Heterogeneous beliefs, trading risk, and the equity premium
Working Paper
Option prices with uncertain fundamentals theory and evidence on the dynamics of implied volatilities
In an incomplete information model, investors' uncertainty about the underlying drift rate of a firm's fundamentals affects option prices through (i) endogenous and belief-dependent stochastic volatility, (ii) stochastic covariance between returns and volatility, and (iii) a market price of "belief risk." For the special case where the drift takes only two values, we provide an option pricing formula using Fourier Transforms. The model calibrated to 1960-1998 S&P 500 real earnings growth shows that investors' uncertainty explains intertemporal variation in the slope and curvature of implied ...