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Jel Classification:G17 

Intraday market making with overnight inventory costs

The U.S. Treasury market is highly intermediated by nonbank principal trading firms (PTFs). Limited capital forces PTFs to end the trading day roughly flat. We construct a continuous time market making model to analyze the trade-off faced by a profit-maximizing firm with overnight inventory costs, and develop closed-form representations of the optimal price policy functions. Our model reveals that bid-ask spreads widen as the end of the trading day approaches, and that increases in order arrival rates do not always lead to higher price volatility. Our empirical analysis shows that ...
Staff Reports , Paper 799

Simple and reliable way to compute option-based risk-neutral distributions

This paper describes a method for computing risk-neutral density functions based on the option-implied volatility smile. Its aim is to reduce complexity and provide cookbook-style guidance through the estimation process. The technique is robust and avoids violations of option no-arbitrage restrictions that can lead to negative probabilities and other implausible results. I give examples for equities, foreign exchange, and long-term interest rates.
Staff Reports , Paper 677

How Interconnected Are Cryptocurrencies and What Does This Mean for Risk Management

In the past couple of years, the market for digital currencies, commonly known as cryptocurrencies because transactions are verified using cryptography, has expanded significantly in terms of transaction volumes, market capitalization, and the number of digital currencies in existence. On January 1, 2018, the market capitalizations (market caps1) of Bitcoin and Ethereum were $226 billion and $75 billion, respectively. By May 10, 2021, Bitcoin’s market cap had reached almost $1 trillion and Ethereum’s $478 billion.In this article, I measure the market’s interconnections in term of prices ...
Chicago Fed Letter , Issue 466 , Pages 5

Working Paper
Nothing is Certain Except Death and Taxes : The Lack of Policy Uncertainty from Expiring \"Temporary\" Taxes

What is the policy uncertainty surrounding expiring taxes? How uncertain are the approvals of routine extensions of temporary tax policies? To answer these questions, I use event studies to measure cumulative abnormal returns (CARs) for firms that claimed the U.S. research and development (R&D) tax credit from 1996-2015. In 1996, the U.S. R&D tax credit was statutorily temporary but was routinely extended ten times until 2015, when it was made permanent. I take the event dates as both when these ten extensions of the R&D tax credit were introduced into committee and when the extensions were ...
Finance and Economics Discussion Series , Paper 2018-041

Global price of risk and stabilization policies

We estimate a highly significant price of risk that forecasts global stock and bond returns as a nonlinear function of the CBOE Volatility Index (VIX). We show that countries? exposure to the global price of risk is related to macroeconomic risks as measured by output, credit, and inflation volatility, the magnitude of financial crises, and stock and bond market downside risk. Higher exposure to the global price of risk corresponds to both higher output volatility and higher output growth. We document that the transmission of the global price of risk to macroeconomic outcomes is mitigated by ...
Staff Reports , Paper 786

Working Paper
Asset Co-movements: Features and Challenges

This paper documents and characterizes the time-varying structure of U.S. and international asset co-movements. Although some of the time variation could be genuine, the sampling uncertainty and time series properties of the series can distort significantly the underlying signal dynamics. We discuss examples that illustrate the pitfalls from drawing conclusions from local trends of asset prices. On a more constructive side, we find that the U.S. main asset classes and major international stock indices share a factor that is closely related to the business cycle. At even lower frequency, the ...
FRB Atlanta Working Paper , Paper 2017-11

Assessing financial stability: the Capital and Loss Assessment under Stress Scenarios (CLASS) model

The CLASS model is a top-down capital stress testing framework that uses public data, simple econometric models, and auxiliary assumptions to project the effect of macroeconomic scenarios on U.S. banking firms. Through the lens of the model, we find that the total banking system capital shortfall under stressful macroeconomic conditions began to rise four years before the financial crisis, peaking in the fourth quarter of 2008. The capital gap has since fallen sharply, and is now significantly below pre-crisis levels. In the cross section, banking firms estimated to be most sensitive to ...
Staff Reports , Paper 663

Working Paper
Variable Annuities: Underlying Risks and Sensitivities

This paper presents a quantitative model designed to understand the sensitivity of variable annuity (VA) contracts to market and actuarial assumptions and how these sensitivities make them a potentially important source of risk to insurance companies during times of stress. VA contracts often include long dated guarantees of market performance that expose the insurer to multiple nondiversifiable risks. Our modeling framework employs a Monte Carlo simulation of asset returns and policyholder behavior to derive fair prices for variable annuities in a risk neutral framework and to estimate ...
Supervisory Research and Analysis Working Papers , Paper RPA 19-1

Working Paper
Bayesian Estimation of Time-Changed Default Intensity Models

We estimate a reduced-form model of credit risk that incorporates stochastic volatility in default intensity via stochastic time-change. Our Bayesian MCMC estimation method overcomes nonlinearity in the measurement equation and state-dependent volatility in the state equation. We implement on firm-level time-series of CDS spreads, and find strong in-sample evidence of stochastic volatility in this market. Relative to the widely-used CIR model for the default intensity, we find that stochastic time-change offers modest benefit in fitting the cross-section of CDS spreads at each point in time, ...
Finance and Economics Discussion Series , Paper 2015-2

Working Paper
Explaining Exchange Rate Anomalies in a Model with Taylor-Rule Fundamentals and Consistent Expectations

We introduce a form of boundedly-rational expectations into a standard asset-pricing model of the exchange rate, where cross-country interest rate differentials are governed by Taylor-type rules. We postulate that agents augment a lagged-information random walk forecast with a term that relates to news about Taylor-rule fundamentals. We solve for a ?consistent expectations equilibrium,? in which the coefficient on fundamental news in the agent?s forecast rule is pinned down using the moments of observable data. The forecast errors observed by the agent are close to white noise, making it di ...
Working Paper Series , Paper 2014-22


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