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Working Paper
Estimation of the optimal futures hedge
Journal Article
Cash flow or present value: what's lurking behind that hedge?
Working Paper
Understanding the risk-return tradeoff in the stock market
We find that past stock market variance forecasts excess stock market returns and that its predictive ability is greatly enhanced if the consumption-wealth ratio is also included in the forecasting equation. While the risk-return tradeoff is found negative if we use the latter as the instrumental variable for the conditional moments, the former suggests positive one. We argue that the consumption-wealth ratio is closely related to the hedge component of excess returns as in Merton's (1973) intertemporal capital asset pricing model: market risk is indeed positively priced if we control for the ...
Discussion Paper
Futures markets and transaction costs
Working Paper
Pricing and hedging index options under stochastic volatility: an empirical examination
An empirical examination of the pricing and hedging performance of a stochastic volatility (SV) model with closed form solution (Heston 1993) is provided for options on the S&P 500 index in which the unobservable time varying volatility is jointly estimated with the time invariant parameters of the model. Although, out-of-sample, the mean absolute pricing error in the SV model is always lower than in the Black-Scholes model, still substantial mispricings are observed for deep out-of-the-money options. The degree of mispricing in different options classes is related to bid-ask spreads on ...
Working Paper
Hedging inflation and income risks
This paper describes potential new markets for long-term inflation risk, and shows the relationship such markets would have to other potential new markets, markets for long-term claims on income aggregates. One inflation-risk market which would be very useful is a market for long-term (or perpetual) claims on a cash flow of constant real value each period, a cash flow measured each period by an index of consumer prices. Such markets need not take the form of indexed government or corporate debt; it would be more natural to create futures-like markets for cash flows tied to an index and paid ...
Report
Market liquidity and trader welfare in multiple dealer markets: evidence from dual trading restrictions
Dual trading is the practice whereby futures floor traders execute trades both for their own and customers' accounts on the same day. We provide evidence, in the context of restrictions on dual trading, that aggregate liquidity measures, such as the average bid-ask spread, may be misleading indicators of traders' welfare in markets with multiple, heterogeneously skilled dealers. In our theoretical model, hedgers and informed customers trade through futures floor traders of different skill levels: more skilled floor traders attract more hedgers to trade. We show that customers' welfare and ...
Working Paper
Exchange rates, optimal debt composition, and hedging in small open economies
This paper develops a model of the firm's choice between debt denominated in local currency and that denominated in foreign currency in a small open economy characterized by exchange rate risk and hedging possibilities. The model shows that the currency composition of debt and the level of hedging are endogenously determined as optimal firms' responses to a tradeoff between the lower cost of borrowing in foreign debt and the higher risk of such borrowing due to exchange rate uncertainty. Both the composition of debt and the level of hedging depend on common factors such as foreign exchange ...
Report
Traders' broker choice, market liquidity and market structure
Hedgers and a risk-neutral informed trader choose between a broker who takes a position in the asset (a capital broker) and a broker who does not (a discount broker). The capital broker exploits order flow information to mimic informed trades and offset hedgers' trades, reducing informed profits and hedgers' utility. But the capital broker has a larger capacity to execute hedgers' orders, increasing market depth. In equilibrium, hedgers choose the broker with the lowest price per unit of utility while the informed trader chooses the broker with the lowest price per unit of the informed order ...