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Working Paper
Variance risk premiums and the forward premium puzzle
This paper presents evidence that the foreign exchange appreciation is predictable by the currency variance risk premium at a medium 6-month horizon and by the stock variance risk premium at a short 1-month horizon. Although currency variance risk premiums are highly correlated with each other over longer horizons, their correlations with stock variance risk premiums are quite low. Interestingly the currency variance risk premium has no predictive power for stock returns. We rationalize these findings in a consumption-based asset pricing model with orthogonal local and global economic ...
Working Paper
The systemic risk of European banks during the financial and sovereign debt crises
We propose a hypothetical distress insurance premium (DIP) as a measure of the European banking systemic risk, which integrates the characteristics of bank size, default probability, and interconnectedness. Based on this measure, the systemic risk of European banks reached its height in late 2011 around ? 500 billion. We find that the sovereign default spread is the factor driving this heightened risk in the banking sector during the European debt crisis. The methodology can also be used to identify the individual contributions of over 50 major European banks to the systemic risk measure. ...
Working Paper
A framework for assessing the systemic risk of major financial institutions
In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro-macro model, takes into account dynamic ...
Working Paper
Term structure of interest rates with regime shifts
We develop a term structure model where the short interest rate and the market price of risks are subject to discrete regime shifts. Empirical evidence from Efficient Method of Moments estimation provides considerable support for the regime shifts model. Standard models, which include affine specifications with up to three factors, are sharply rejected in the data. Our diagnostics show that only the regime shifts model can account for the well documented violations of the expectations hypothesis, the observed conditional volatility, and the conditional correlation across yields. We find that ...
Working Paper
Specification analysis of structural credit risk models
In this paper we conduct a specification analysis of structural credit risk models, using term structure of credit default swap (CDS) spreads and equity volatility from high-frequency return data. Our study provides consistent econometric estimation of the pricing model parameters and specification tests based on the joint behavior of time-series asset dynamics and cross-sectional pricing errors. Our empirical tests reject strongly the standard Merton (1974) model, the Black and Cox (1976) barrier model, and the Longstaff and Schwartz (1995) model with stochastic interest rates. The double ...
Working Paper
Effects of liquidity on the nondefault component of corporate yield spreads: evidence from intraday transactions data
We estimate the nondefault component of corporate bond yield spreads and examine its relationship with bond liquidity. We measure bond liquidity using intraday transactions data and estimate the default component using the term structure of credit default swaps spreads. With swap rate as the risk free rate, the estimated nondefault component is generally moderate but statistically significant for AA-, A-, and BBB-rated bonds and increasing in this order. With Treasury rate as the risk free rate, the estimated nondefault component is the largest in basis points for BBB-rated bonds but, as a ...
Working Paper
Expected stock returns and variance risk premia
We find that the difference between implied and realized variances, or the variance risk premium, is able to explain more than fifteen percent of the ex-post time series variation in quarterly excess returns on the market portfolio over the 1990 to 2005 sample period, with high (low) premia predicting high (low) future returns. The magnitude of the return predictability of the variance risk premium easily dominates that afforded by standard predictor variables like the P/E ratio, the dividend yield, the default spread, and the consumption-wealth ratio (CAY). Moreover, combining the variance ...
Working Paper
Estimating stochastic volatility diffusion using conditional moments of integrated volatility
We exploit the distributional information contained in high-frequency intraday data in constructing a simple conditional moment estimator for stochastic volatility diffusions. The estimator is based on the analytical solutions of the first two conditional moments for the latent integrated volatility, the realization of which is effectively approximated by the sum of the squared high-frequency increments of the process. Our simulation evidence indicates that the resulting GMM estimator is highly reliable and accurate. Our empirical implementation based on high-frequency five-minute foreign ...
Working Paper
Stock return predictability and variance risk premia: statistical inference and international evidence
Recent empirical evidence suggests that the variance risk premium, or the difference between risk-neutral and statistical expectations of the future return variation, predicts aggregate stock market returns, with the predictability especially strong at the 2-4 month horizons. We provide extensive Monte Carlo simulation evidence that statistical finite sample biases in the overlapping return regressions underlying these findings can not ``explain" this apparent predictability. Further corroborating the existing empirical evidence, we show that the patterns in the predictability across ...
Working Paper
Bond risk premia and realized jump volatility
We find that adding a measure of market jump volatility risk to a regression of excess bond returns on the term structure of forward rates nearly doubles the R square of the regression. Our market jump volatility measure is based on the realized jumps identified from high-frequency stock market returns using the bi-power variation technique. The significant enhancement of bond return predictability is robust to different forecasting horizons, to using non-overlapping returns and to the choice of different window sizes in computing the jump volatility. This market jump volatility factor also ...