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Report
The cost of capital of the financial sector
Standard factor pricing models do not capture well the common time-series or cross-sectional variation in average returns of financial stocks. We propose a five-factor asset pricing model that complements the standard Fama and French (1993) three-factor model with a financial sector ROE factor (FROE) and the spread between the financial sector and the market return (SPREAD). This five-factor model helps to alleviate the pricing anomalies for financial sector stocks and also performs well for nonfinancial sector stocks compared with the Fama and French (2014) five-factor model or the Hou, Xue, ...
Working Paper
Too Good to Be True? Fallacies in Evaluating Risk Factor Models
This paper is concerned with statistical inference and model evaluation in possibly misspecified and unidentified linear asset-pricing models estimated by maximum likelihood and one-step generalized method of moments. Strikingly, when spurious factors (that is, factors that are uncorrelated with the returns on the test assets) are present, the models exhibit perfect fit, as measured by the squared correlation between the model's fitted expected returns and the average realized returns. Furthermore, factors that are spurious are selected with high probability, while factors that are useful are ...
Report
Broker-dealer risk appetite and commodity returns
This paper shows that the risk-bearing capacity of U.S. securities brokers and dealers is a strong determinant of risk premia in commodity derivatives markets. Commodity derivatives are the principal instrument used by producers and purchasers of commodities to hedge against commodity price risk. Broker-dealers play an important role in this hedging process because commodity derivatives are traded primarily over the counter. I capture the limits of arbitrage in this market in a simple asset pricing model where producers and purchasers of commodities share risk with broker-dealers who are ...
Working Paper
General Aggregation of Misspecified Asset Pricing Models
This paper proposes an entropy-based approach for aggregating information from misspecified asset pricing models. The statistical paradigm is shifted away from parameter estimation of an optimally selected model to stochastic optimization based on a risk function of aggregation across models. The proposed method relaxes the perfect substitutability of the candidate models, which is implicitly embedded in the linear pooling procedures, and ensures that the aggregation weights are selected with a proper (Hellinger) distance measure that satisfies the triangle inequality. The empirical results ...
Working Paper
A Currency Premium Puzzle
Standard asset pricing models reconcile high equity premia with smooth risk-free rates by inducing an inverse functional relationship between the mean and the variance of the stochastic discount factor. This highly successful resolution to closed-economy asset pricing puzzles is fundamentally problematic when applied to open economies: It requires that differences in currency returns arise almost exclusively from predictable appreciations, not from interest rate differentials. In the data, by contrast, exchange rates are largely unpredictable, and currency returns arise from persistent ...
Report
Risk appetite and exchange Rates
We present evidence that the growth of U.S.-dollar-denominated banking sector liabilities forecasts appreciations of the U.S. dollar, both in-sample and out-of-sample, against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a global banking model where exchange rates fluctuate as a function of banks? balance sheet capacity. We estimate prices of risk using a cross-sectional asset pricing approach and show that the U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. Our ...
Report
Nonparametric pricing of multivariate contingent claims
In this paper, I derive and implement a nonparametric, arbitrage-free technique for multivariate contingent claim (MVCC) pricing. Using results from the method of copulas, I show that the multivariate risk-neutral density can be written as a product of marginal risk-neutral densities and a risk-neutral dependence function. I then develop a pricing technique using nonparametrically estimated marginal risk-neutral densities (based on options data) and a nonparametric dependence function (based on historical return data). By using nonparametric estimation, I avoid the pricing biases that result ...
Working Paper
Bubbles and Leverage: A Simple and Unified Approach
In this paper, we lay out a simple framework that captures much of what the theoretical literature has to say about the role of credit in systemically important asset booms and busts. In addition, we suggest ways in which to incorporate physical investment in the bubble asset as well as monetary policy.
Working Paper
Estimating Yield Impacts of Treasury Demand and Supply Changes
We develop a rich demand system framework to quantify the yield effects of shifts in U.S. Treasury supply and demand. Our model captures time-varying holdings shares and estimates sectoral demand elasticities using instrumental variables. We find that the Treasury market has become increasingly price-sensitive over time, driven by the declining participation of less price-sensitive foreign official investors and the rising role of more price-sensitive hedge funds and other private investors. A $100 billion increase in Treasury supply currently raises five-year yields by approximately 3 basis ...
Report
Excess volatility of exchange rates with unobservable fundamentals
We present tests of excess volatility of exchange rates that impose minimal structure on the data and do not commit to a choice of exchange rate "fundamentals." Our method builds on existing volatility tests of asset prices, combining them with a procedure that extracts unobservable fundamentals from survey-based exchange rate expectations. We apply our method to data for the three major exchange rates since 1984 and find broad evidence of excess volatility with respect to the predictions of the canonical asset-pricing model of the exchange rate with rational expectations.