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Jel Classification:G12 

Report
Tick size change and market quality in the U.S. treasury market

This paper studies the effects of a recent tick size reduction in the U.S. Treasury securities market. Employing difference-in-differences regressions, we find significantly narrower bid-ask spreads and increased trading activity. Market depth declines overall, but depth close to the top of the book changes little. The smaller tick size enables prices to adjust more easily to information and allows traders to quickly capture their information advantage, resulting in greater price efficiency and an information shift toward the smaller-tick cash market from the futures market. Overall, we ...
Staff Reports , Paper 886

Report
Horizon-Dependent Risk Aversion and the Timing and Pricing of Uncertainty

Inspired by experimental evidence, we amend the recursive utility model to let risk aversion decrease with the temporal horizon. Our pseudo-recursive preferences remain tractable and retain appealing features of the long-run risk framework, notably its success at explaining asset pricing moments. Calibrating the agents? preferences to explain the market returns observed in the data no longer implies an extreme preference for early resolutions of uncertainty and captures key puzzles in finance on the valuation and demand for risk at long maturities.
Staff Reports , Paper 703

Report
The equity risk premium: a review of models

We estimate the equity risk premium (ERP) by combining information from twenty models. The ERP in 2012 and 2013 reached heightened levels?of around 12 percent?not seen since the 1970s. We conclude that the high ERP was caused by unusually low Treasury yields.
Staff Reports , Paper 714

Report
Deconstructing the yield curve

We investigate the factor structure of the term structure of interest rates and argue that characterizing the minimal dimension of the data generating process is more challenging than currently appreciated. As a result, inference procedures for yield curve models that commit to a parsimoniously parameterized factor structure may be omitting important information about the underlying true factor space. To circumvent these difficulties, we introduce a novel nonparametric bootstrap that is robust to general forms of time and cross-sectional dependence and conditional heteroskedasticity of ...
Staff Reports , Paper 884

Report
Understanding mortgage spreads

Most mortgages in the U.S. are securitized in agency mortgage-backed securities (MBS). Yield spreads on these securities are thus a key determinant of homeowners? funding costs. We study variation in MBS spreads over time and across securities, and document a cross-sectional smile pattern in MBS spreads with respect to the securities? coupon rates. We propose non-interest-rate prepayment risk as a candidate driver of MBS spread variation and present a new pricing model that uses ?stripped? MBS prices to identify the contribution of this prepayment risk to the spread. The pricing model finds ...
Staff Reports , Paper 674

Report
Arbitrage-free affine models of the forward price of foreign currency

Forward foreign exchange contracts embed not only expected depreciation but also a sizable premium, which complicates inferences about anticipated returns. This study derives arbitrage-free affine forward currency models (AFCMs) with closed-form expressions for both unobservable variables. Model calibration to forward term structures of eleven U.S.-dollar currency pairs from the mid-to-late 1990s through early 2014 fits the data closely and suggests that the premium is indeed nonzero and variable, but not to the degree implied by previous econometric studies.
Staff Reports , Paper 665

Report
Evaluating regulatory reform: banks’ cost of capital and lending

We examine the effects of regulatory changes on banks? cost of capital and lending. Since the passage of the Dodd-Frank Act, the value-weighted CAPM cost of capital for banks has averaged 10.5 percent and declined by more than 4 percent relative to nonbanks on a within-firm basis. This decrease was much greater for larger banks subject to new regulation than for smaller banks. Over a longer twenty-year horizon, we find that changes in the systematic risk of bank equity have real economic consequences: increases in banks? cost of capital are associated with tightening in credit supply and loan ...
Staff Reports , Paper 854

Report
LIBOR: origins, economics, crisis, scandal, and reform

The London Interbank Offered Rate (LIBOR) is a widely used indicator of funding conditions in the interbank market. As of 2013, LIBOR underpins more than $300 trillion of financial contracts, including swaps and futures, in addition to trillions more in variable-rate mortgage and student loans. LIBOR's volatile behavior during the financial crisis provoked questions surrounding its credibility. Ongoing regulatory investigations have uncovered misconduct by a number of financial institutions. Policymakers across the globe now face the task of reforming LIBOR in the aftermath of the scandal and ...
Staff Reports , Paper 667

Report
Option-implied term structures

This paper proposes a nonparametric sieve regression framework for pricing the term structure of option spanning portfolios. The framework delivers closed-form, nonparametric option pricing and hedging formulas through basis function expansions that grow with the sample size. Novel confidence intervals quantify term structure estimation uncertainty. The framework is applied to estimating the term structure of variance risk premia and finds that a short-run component dominates market excess return predictability. This finding is inconsistent with existing asset pricing models that seek to ...
Staff Reports , Paper 706

Report
The term structure of expectations and bond yields

Bond yields can be decomposed into expected short rates and term premiums. We directly measure the former using all available U.S. professional forecasts and obtain the latter as the difference between bond yields and survey-based expected short rates. While the behavior of nominal and real short rate expectations is consistent with standard macroeconomic theory, term premiums account for the bulk of the cross-sectional and time series variation in yields. They also largely explain the yield curve's reaction to a host of structural economic shocks. This dramatic failure of the expectations ...
Staff Reports , Paper 775

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