Browsing by Subject "Asset pricing"

This dissertation consists of three essays on asymmetric correlations in financial markets. In the first essay, I have two main contributions. First, I show that dividend growth rates have symmetric correlations. Second, I show that asymmetric correlations are different than correlations being counter-cyclical. The correlation asymmetry I study in this dissertation should not be confused with correlations being counter-cyclical, i.e. being higher during recessions than during booms. I show that while counter-cyclical correlations can simply be explained by counter-cyclical aggregate market volatility, the correlation asymmetry with respect to joint upside and downside movements of returns are not just due to the heightened market volatility during those times.

In the second essay I present a model in order to explain the correlation asymmetry observed in the data. This is the first paper to offer an explanation for observed correlation asymmetry. I formalize the explanation using an equilibrium model. The model is useful to understand both the cross-section and time-series of correlation asymmetry. By the means of my model, we can answer questions about why some stocks have higher correlation asymmetry, and why the correlation asymmetry was higher during 1990s? In the model asset prices respond the realization of dividends and news about the future. However, price responses to news are asymmetric and this asymmetry is endogenous. Price responses are endogenously stronger conditional on bad news than conditional on good news. This asymmetry also generates the observed correlation asymmetry. The price responses are asymmetric due to the ambiguity about the news quality. Information about the quality of the signal is incomplete in the sense that the exact precision of the signal is unknown; it is only known to be in an interval, which makes the representative agent treat news as ambiguous. To model ambiguity aversion, I use Gilboa and Schmeidler (1989)'s max-min expected utility representation. The agent has a set of beliefs about the quality of signals, and the ambiguity-averse agent behaves as if she maximizes expected utility under a worst-case scenario. This incomplete information about the news quality, together with ambiguity-averse agents, generates an asymmetric response to news. Endogenous worst-case scenarios differ depending on the realization of news. When observing ``bad" news, the worst-case scenario is that the news is reliable and the prices of trees decrease strongly. On the other hand, when ``good news" is observed, under the worst-case scenario the news is evaluated as less reliable, and thus the price increases are mild. Therefore, price responses are stronger conditional on a negative signal and this asymmetry creates a higher correlation conditional on a negative signal than conditional on a positive signal. I also show that the results are robust to the smooth ambiguity aversion representation.

Motivated by the model, I uncover a new empirical regularity that is unknown in the literature. I show that correlation asymmetry is related to idiosyncratic volatility: the higher the idiosyncratic volatility, the higher the correlation asymmetry. This novel empirical finding is also useful to understand the time-series and cross-sectional variation in correlation asymmetry. Stocks with smaller market capitalizations have greater correlation asymmetry compared to stocks with higher market capitalization. However, an explanation for this finding has been lacking. According to the explanation offered in this paper, smaller size stocks have greater correlation asymmetry compared to bigger size stocks because small size stocks tend to have higher idiosyncratic volatilities compared to bigger size stocks. In the time-series, correlation asymmetry shows quite significant variation as well. The average correlation asymmetry is especially high for the 1990s and decreases significantly at the beginning of the 2000s. This pattern in times-series can also be explained in terms of the time-series behavior of idiosyncratic volatilities. Several papers including Brandt et al. (2010), document higher idiosyncratic volatilities during 1990s while the aggregate volatility stays fairly stable. Basically, the high idiosyncratic volatilities during the 1990s also caused greater correlation asymmetry.

In the third essay, I study the correlation of returns in government bond markets. Similar to the findings in equity markets, I show that there is some evidence for asymmetric correlations in government bond markets. First, I show that the maturity structure matters for correlation asymmetry in bonds markets: Unlike long-maturity bonds, shorter-maturity bonds tend to have asymmetric correlations. Second, I show that the correlation asymmetry observed in European bond markets disappears with the formation of a common currency area. Lastly, I study the correlation between equity and bond returns in different countries. For long-maturity bonds, correlations with the domestic equity returns are asymmetric for half of the countries in the sample, including the U.S. These findings show that results on asymmetric correlations from equity markets can generalize, at least to some extent, to other financial markets.

This dissertation consists of three essays that shed light on various problems in empirical asset pricing and portfolio management by applying high frequency econometric techniques. Chapter 1, An Efficient Factor from Basis “Anomalies”, examines the challenges brought by the massive asset-pricing “anomalies” and develops a novel method to construct a highly ex-post efficient portfolio that prices asset returns in a one-factor model, Relative Asset Pricing Model (RAP). The one single empirical factor outperforms and drives out 11 of the most acclaimed multi-factors combined. It provides evidence that the massive amount of asset pricing “anomalies” are in fact manifested by non-linear effects of three basic stock characteristics, size, book-to-market and momentum. It also demonstrates that an arbitrary number of trading signals can be engineered to pass existing asset pricing tests as new “unique anomalies”, even though they are purely the projections of the efficient factor beta onto a set of characteristics. Chapter 2, Good Volatility, Bad Volatility and the Cross Section of Stock Returns, documents that relative good-minus-bad jump measure extracted from high frequency intra-day data have strong cross-sectional return predictability. Chapter 3, Factors and Their Economic Value in Volatility Forecast, develops a simple and reliable volatility forecast model in large cross-section that incorporates volatility factor structure and add significant values to investors in portfolio optimization.

In my dissertation, I study the link between economic growth and asset prices in stochastic endogenous growth models. In these settings, long-term growth prospects are endogenously determined by innovation and R\&D. In equilibrium, R\&D endogenously drives a small, persistent component in productivity which generates long-run uncertainty about economic growth. With recursive preferences, this growth propagation mechanism helps reconcile a broad spectrum of equity and bond market facts jointly with macroeconomic fluctuations.

This dissertation is a collection of papers with the unifying objective being to better understand crash risk in foreign exchange markets. I investigate how exposure to the risk of currency crashes is able to provide a unified rationalization of the returns of various sorted currency portfolios.

In the first chapter, I identify an aggregate global currency skewness risk factor, which I denote SKEW. Currency portfolios that have higher average excess returns covary more positively with this risk factor. They suffer losses in times when high interest rate investment currencies have a greater tendency to depreciate sharply as a group relative to low interest rate funding currencies. Consequently, they earn higher average excess returns as reward for exposure to this risk. I create three sets of sorted currency portfolios reflecting three distinct sources of variation in average excess currency returns. The first set sorts currencies based on interest rate differentials. The second set sorts currencies based on currency momentum. The third set sorts currencies based on currency undervaluedness relative to purchasing power power parity (PPP) implied exchange rates. I find that differences in exposure to the global currency skewness risk factor can explain the systematic variation in average excess currency returns within all three groups of portfolios much better than existing foreign exchange risk factors in the literature.

In the second chapter, I build on the first chapter by studying the extent to which currency crash risk is predictable or unpredictable and whether the pricing power of aggregate currency skewness, uncovered in the first chapter, is due to unpredictable or predictable crash risk. Focusing on currency crash risk proxied using realized currency skewness at both the individual currency level and at the aggregate level using the SKEW risk factor introduced in the first chapter, I investigate whether either form of crash risk is predictable using only past information about crash risk. In particular, I use past information on both individual currency level and aggregate level measures based on both lagged realized currency skewness and lagged option implied risk neutral skewness. I find evidence that there is not much predictability at the individual country level or at the aggregate level over the full sample period considered. However, there is some evidence of predictability at the aggregate level since 1999, and especially so when option implied risk neutral skewness measures are used. Additionally, I use the predictions of SKEW and conduct asset pricing similar to that in chapter 1 using predicted and unpredicted SKEW to see whether its pricing power comes from predictable or unpredictable components. I find evidence that it is unpredictable currency crash risk that is very important, as the asset pricing results are largely identical when either SKEW or SKEW forecast errors are used. and whether the pricing power of

My Ph.D. dissertation is composed of two chapters studying how monetary policy influences asset prices.

The first chapter empirically explores the effects of the Federal Reserve (Fed)'s large-scale asset purchasing (LSAP) program on the cross-section of equity returns through financial intermediaries' funding liquidity. Using the LSAP shock by Swanson (2017) as a policy measure and the Liquidity Mismatch Index by Bai et al. (2017) as a funding liquidity measure of intermediaries, I show that an expansionary policy shock increases the stock return of banks with low liquidity more than those with high liquidity. In addition, the liquidity of lenders also influences their borrowers' equity prices through their sticky loan contracts. Firms borrowing from low liquidity banks, and of high loan-to-asset ratio earn relatively higher returns under the same expansionary shock. The response of borrowers is weaker, more delayed, and more persistent than that of lenders. These findings collectively provide supportive evidence of the bank lending channel as a policy transmission mechanism in the quantitative easing period.

The second chapter theoretically analyzes how monetary policy feedback rule can influence the risk premium of financial assets in a New Keynesian general equilibrium model where a firm's default is endogenously determined from the limited liability of stockholders, and nominal price and wage rigidity exist. A productivity (monetary policy) shock shifts supply (demand) curve, causing output comove positively (negatively) with inflation. A policy rule to output and inflation determines the magnitude of output response to those shocks, determining the price of risk and the procyclicality of dividend. Higher (lower) inflation and lower (lower) output feedback lead to higher equity premium driven by a productivity (policy) risk. This trend is robust to the source of nominal rigidity. Under a baseline calibration, the model generates 1.76% (1.87%) of the annual levered (unlevered) equity risk premium, indicating an endogenous leverage does not amplify the equity return. The countercyclicality of the default rate in the model generates a credit risk premium, but does not amplify the overall credit spread. Producing reasonable asset pricing dynamics based on New Keynesian production-based models remains challenge.

I provide new evidence on the properties of the temporal structure of risk, which answers whether more distant claims to macroeconomic growth are more or less risky than near-term claims. In the first chapter, I use replication and no-arbitrage to estimate within-firm variation in equity expected returns across horizons. I demonstrate that a low dimensional set of returns and state variables, all characteristics of liquid, exchange-traded equity securities, provide a close replication of claims to firm capital gains at different horizons. Calculating returns from the no-arbitrage prices of these claims, I show that the term structure of risk premia is unconditionally upward-sloping for commonly used test assets like the market and book-to-market sorted portfolios. In joint work in the second chapter, we use traded equity dividend strips from U.S., Europe, and Japan from 2004-2017 to study the slope of the term structure of equity dividend risk premia. In the data, our robust finding is that the term structure of dividend risk premia (growth rates) is positively (negatively) sloped in expansions and negatively (positively) sloped in recessions. We develop a consumption-based regime switching model which matches these robust data-features and the historical probabilities of recession and expansion regimes. The unconditional population term structure of dividend risk premia in the regime-switching model, as in standard asset pricing models (habits and long-run risks), is increasing with maturity. In sum, our analysis shows that the empirical evidence in dividend strips is consistent with a positively sloped term structure of dividend risk-premia as implied by standard asset pricing models.