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 ...
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 ...
Betting against beta (and gamma) using government bonds
Purportedly consistent with ?risk parity? (RP) asset allocation, recent studies document compelling ?low risk? trading strategies that exploit a persistently negative relation between Sharpe ratios (SRs) and maturity along the U.S. Treasury (UST) term structure. This paper extends this evidence on betting against beta with government bonds (BABgov) in four respects. First, out-of-sample tests suggest that excess returns may have waned somewhat recently and that the pattern seems most pronounced for USTs given data on ten other previously unexamined government bond markets. Second, BABgov ...
Spurious Inference in Unidentified Asset-Pricing Models
This paper studies some seemingly anomalous results that arise in possibly misspecified and unidentified linear asset-pricing models estimated by maximum likelihood and one-step generalized method of moments (GMM). Strikingly, when useless factors (that is, factors that are independent of 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, and the tests for correct model specification have asymptotic power that is equal to the nominal size. In other ...
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, ...
Asymptotic variance approximations for invariant estimators in uncertain asset-pricing models
This paper derives explicit expressions for the asymptotic variances of the maximum likelihood and continuously updated GMM estimators under potentially misspecified models. The proposed misspecification-robust variance estimators allow the researcher to conduct valid inference on the model parameters even when the model is rejected by the data. Although the results for the maximum likelihood estimator are only applicable to linear asset-pricing models, the asymptotic distribution of the continuously updated GMM estimator is derived for general, possibly nonlinear, models. The large ...
Intermediary leverage cycles and financial stability
We present a theory of financial intermediary leverage cycles within a dynamic model of the macroeconomy. Intermediaries face risk-based funding constraints that give rise to procyclical leverage and a procyclical share of intermediated credit. The pricing of risk varies as a function of intermediary leverage, and asset return exposures to intermediary leverage shocks earn a positive risk premium. Relative to an economy with constant leverage, financial intermediaries generate higher consumption growth and lower consumption volatility in normal times, at the cost of endogenous systemic ...
The Private Premium in Public Bonds?
In a 2012 New York Fed study, Chenyang Wei and I find that interest rate spreads on publicly traded bonds issued by companies with privately traded equity are about 31 basis points higher on average than spreads on bonds issued by companies with publicly traded equity, even after controlling for risk and other factors. These differences are economically and statistically significant and they persist in the secondary market. We control for many factors associated with bond pricing, including risk, liquidity, and covenants. Although these controls account for some of the absolute pricing ...
The impact of the pandemic and the Fed’s muni program on Illinois muni yields
We estimate a simple model in which variations in Illinois daily municipal bond yields are explained by high-frequency indicators summarizing economic and public health conditions in Illinois, as well as key changes in the Federal Reserve’s Municipal Liquidity Facility (or MLF). We find that the MLF appears to have reduced Illinois muni yields by more than 200 basis points.
Show me the money: the monetary policy risk premium
We study how monetary policy affects the cross-section of expected stock returns. For this purpose, we create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that are theoretically linked to how firms react to monetary policy. We find that stocks whose prices react more positively to expansionary monetary policy surprises earn lower average returns. This finding is consistent with the intuition that monetary policy is expansionary in bad economic times when the marginal value of wealth is high, and thus high MPE stocks serve as a hedge against bad ...