Working Papers

The Term Structure of Currency Carry Trade Risk Premia (new paper) 
(with Adrien Verdelhan and Andreas Stathopoulos)

High interest rate currencies yield high currency excess returns on short-term Treasury bill investments, but they tend to yield low local excess returns on long-term government bonds. At longer maturities, the low term premium offsets the high currency risk premium. Under no arbitrage conditions, this exact result obtains when global permanent innovations to the pricing kernels of different countries are the same and therefore do not to have permanent effects on exchange rates. In this case, the uncovered interest rate parity holds at long horizons. We derive parametric restrictions to match the downward sloping term structure of carry trade risk premia in a large class of affine term structure models. 

Firm Volatility in Granular Networks (new paper) 
(with Bryan Kelly and Stijn Van Nieuwerburgh)

We propose a network model of firm volatility in which the customers’ growth rate shocks influence the growth rates of their suppliers, larger suppliers have more customers, and the strength of a customer-supplier link depends on the size of the customer firm. Even though all shocks are i.i.d., the network model produces firm-level volatility and size distribution dynamics that are consistent with the data. In the cross section, larger firms and firms with less concentrated customer networks display lower volatility. Over time, the volatilities of all firms co-move strongly, and their common factor is concentration of the economy-wide firm size distribution. Network effects are essential to explaining the joint evolution of the empirical firm size and firm volatility distributions.

The Common Factor in Idiosyncratic Volatility: Quantitative Asset Pricing Implications
 (new paper) 
(with Bryan Kelly and Stijn Van Nieuwerburgh)

Firm-level volatility obeys a strong factor structure. The factor structure is distinct from the common variation in the returns themselves - after removing common factors in returns, residuals are uncorrelated, yet idiosyncratic volatility possess the same factor structure as total volatility. In fact, idiosyncratic volatility dominates firms' total variation - less that 5% of variation in daily returns is accounted for by common factors. The volatility factor structure holds not only for returns, but also for firm-level cash flow growth volatility. Thus any explanation of the volatility factor structure must account for both fundamental and return volatility, ruling out arguments based purely on discount rates or investor behavior.

Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees (winner of the JP Morgan Award for the best paper on Financial Institutions and Markets--WFA, 2012)
(with Bryan Kelly and Stijn Van Nieuwerburgh)

A conspicuous amount of aggregate tail risk is missing from the price of financial sector crash insurance during the 2007-2009 crisis. The difference in costs of out-of-the-money put options for individual banks, and puts on the financial sector index, increases fourfold from its pre-crisis level. At the same time, correlations among bank stocks surge, suggesting the high put spread cannot be attributed to a relative increase in idiosyncratic risk. We show that this phenomenon is unique to the financial sector, that it cannot be explained by observed risk dynamics (volatilities and correlations), and that illiquidity and no-arbitrage violations are unlikely culprits. Instead, we provide evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks, explaining the divergence in the basket-index spread. By embedding a bailout in the standard one-factor option pricing model, we can closely replicate observed put spread dynamics. During the crisis, the spread responds acutely to government intervention announcements.

Deflation Risk (new paper)
(with Francis Longstaff and Matthias Fleckenstein)

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5 percent over the next 30 years. Despite this, the market places substantial probability weight on deflation scenarios in which prices decline by more than 10 to 20 percent over extended horizons. We find that the market prices the economic tail risk of deflation very similarly to other types of tail risks such as catastrophic insurance losses. In contrast, inflation tail risk has only a relatively small premium. Deflation risk is also significantly linked to measures of financial tail risk such as swap spreads, corporate credit spreads, and the pricing of super senior tranches. These results indicate that systemic financial risk and deflation risk are closely related.

(with Michael Katz and Lars Nielsen)

Local stock markets adjust sluggishly to changes in local inflation. Over short investment horizons of less than a year, the nominal returns on a country's local stock market index do not respond to country-specific variation in the rate of inflation. As a result, when the local rate of inflation increases, local investors subsequently earn significantly lower real returns on local stocks, but not on local bonds or foreign stocks. The marginal stock market investor seems slow to incorporate news about the future path of local inflation into nominal discount rates, but the marginal bond and currency market investor is not.

(with Ralph Koijen and Stijn Van Nieuwerburgh)

Value stocks have higher exposure to innovations in the nominal bond risk premium, which measures the markets' perception of cyclical variation in future output growth, than growth stocks. The ICAPM then predicts a value risk premium provided that good news about future output lowers the marginal utility of investors' wealth today. In support of the business cycle as a priced state variable, we show that low value minus growth returns, typically realized at the start of recessions when nominal bond risk premia are low and declining, are associated with lower future dividend growth rates on value minus growth and with lower future output growth in the short term. Because of this new nexus between stock and bond returns, a parsimonious three-factor model can jointly price the book-to-market stock and maturity-sorted bond portfolios and reproduce the time-series variation in expected bond returns. Structural dynamic asset pricing models need to impute a central role to the business cycle as a priced state variable to be quantitatively consistent with the observed value, equity, and nominal bond risk premia.