Publications

Dynamic ESG equilibrium (with Doron Avramov, Abraham Lioui, and Yang Liu)

Management Science, 2024.

https://doi.org/10.1287/mnsc.2022.03491

Abstract: This paper proposes a conditional asset pricing model that integrates ESG demand and supply dynamics. Shocks in the demand for sustainable investing represent a novel risk source, characterized by diminishing marginal utility and positive premium. Green assets exhibit positive exposure to ESG demand shocks, hence commanding higher premia. Conversely, time-varying convenience yield leads to lower expected returns for green assets. Moreover, ESG demand shocks have positive contemporaneous effects on unexpected returns, contributing to large positive payoffs in the green-minus-brown portfolio over extended horizons. The model predictions align closely with evidence on return spreads between green and brown assets, further reinforcing the apparent gap between realized and expected spreads.

Money illusion and TIPS demand (with Abraham Lioui)

Journal of Money, Credit and Banking, 2023, 55(1), 171-214.

https://doi.org/10.1111/jmcb.12923

Abstract: The market demand for the Treasury Inflation-Protected Securities (TIPS) is rather small. This is puzzling, as we show that an agent, who derives utility from real wealth and dynamically invests into multiple asset classes over a 30-year horizon, incurs a certainty equivalent loss of 1.6% per annum from not investing in inflation-indexed bonds. However, if the investor suffers from money illusion, the perceived loss is only 0.5% per annum. Furthermore, the perceived loss is totally negligible for an unsophisticated money-illusioned investor ignoring the time variation of risk premia. Money illusion causes significant portfolio shifts from inflation-indexed toward nominal bonds, with little effects on equity allocations, contributing to the low market demand for TIPS.

Sustainable investing with ESG rating uncertainty (with Doron Avramov, Si Cheng, and Abraham Lioui)

Journal of Financial Economics, 2022, 145(2), 642-664.

https://doi.org/10.1016/j.jfineco.2021.09.009

Abstract: This paper analyzes the asset pricing and portfolio implications of an important barrier to sustainable investing: uncertainty about the corporate ESG profile. In equilibrium, the market premium increases and demand for stocks declines under ESG uncertainty. In addition, the CAPM alpha and effective beta both rise with ESG uncertainty and the negative ESG-alpha relation weakens. Employing the standard deviation of ESG ratings from six major providers as a proxy for ESG uncertainty, we provide supporting evidence for the model predictions. Our findings help reconcile the mixed evidence on the cross-sectional ESG-alpha relation and suggest that ESG uncertainty affects the risk-return trade-off, social impact, and economic welfare.

Chasing the ESG factor (with Abraham Lioui)

Journal of Banking and Finance, 2022, 139, 106498.

https://doi.org/10.1016/j.jbankfin.2022.106498

Abstract: We analytically compare two dominant methodologies for the construction of an ESG factor: the time-series (ratings used to sort stocks) and cross-sectional (ratings used to weight stocks) approaches. Differences in ESG rating and exposure to other firm characteristics imply an ex ante expected return spread between the two factors. We construct a cross-sectional factor (i) featuring a targeted rating, thus allowing comparability with other factors, (ii) neutralizing exposure to other firm characteristics, and (iii) not harming diversification through stock screening. Using ratings from several data vendors, we document strong variations of the factor alpha in the time series and across vendors. The conditional alpha is negatively related to the level of media attention for ESG and positively related to variations in media attention.

Bail-in vs bail-out: Bank resolution and liability structure  (with Luca Leanza and Alessandro Sbuelz)

International Review of Financial Analysis, 2021, 73, 101642.

https://doi.org/10.1016/j.irfa.2020.101642

Abstract: We study the optimal liability structure of a bank under different resolution regimes and capital requirements. We do so by developing a structural model, allowing for bail-in and default events triggered either endogenously or by an external regulator, for a bank holding insured deposits and issuing covered (non-bail-inable) and uncovered (bail-inable) debt. As opposed to a bail-out resolution regime, a credible bail-in resolution regime endogenously reduces leverage and mitigates default risk. A strict enforcement of the Common Equity Tier 1 (CET1) capital requirement, as introduced by the Basel III regulation, entails a dramatic reduction of the optimal bank leverage.

Factor investing for the long run (with Abraham Lioui)

Journal of Economic Dynamics and Control, 2020, 117, 103960.

https://doi.org/10.1016/j.jedc.2020.103960

Abstract: Anomaly-based long/short benchmarks are typically built from portfolios double-sorted on size and one additional characteristic, applying simple fixed-weights schemes. Characteristic-based portfolios show significant time variations of their abnormal returns (alphas) and market exposures (betas). While timing alphas is challenging, a long-term risk-averse investor benefits from implementing dynamic weighting schemes that account for the time variation of the betas of the portfolios. Particularly for long investment horizons, significant out-of-sample Sharpe ratio improvements and utility gains with respect to fixed-weights factor benchmarks are recorded using portfolios sorted on size, value, operating profitability, investment and momentum.

Structural recovery of face value at default (with Rajiv Guha and Alessandro Sbuelz)

European Journal of Operational Research, 2020, 283(3), 1148-1171.

https://doi.org/10.1016/j.ejor.2019.11.057

Abstract: We carefully study the transmission mechanisms from default-free rates to corporate bond prices within structural models of endogenous default risk. The transmission critically depends on whether the model is value-based or cashflow-based, on the assumptions made for the drift of the state variable, and on the way the residual value at default is shared among bondholders. The recovery assumption is crucial: Recovery of Face Value, which entails receiving the same share of residual value at default regardless of the remaining maturity, greatly helps explaining the empirical evidence on bond-price sensitivities to interest rates. 

Macroeconomic environment, money demand and portfolio choice (with Abraham Lioui)

European Journal of Operational Research, 2019, 274(1), 357-374.

https://doi.org/10.1016/j.ejor.2018.09.039

Abstract: We solve the portfolio choice problem of a long-term investor holding real balances, a stock index, multiple bonds and a remunerated money market account. We relate the factors driving the term structure and the equity premium to macroeconomic variables. When expected inflation decreases, the investor allocates more to the stock market, long-term bonds and unrewarded real balances, reducing short-maturity deposits. The optimal money demand: i) entails time variations in risk aversion; ii) reduces bond market positions when the importance of money in preferences increases, with little impact on the stock market participation; and iii) has quantitative implications in terms of horizon effects.

Capital structure decisions and the optimal design of corporate market debt programs (with Lionel Martellini and Vincent Milhau)

The Journal of Corporate Finance, 2018, 49, 141-167.

https://doi.org/10.1016/j.jcorpfin.2017.11.011

Abstract: This paper provides a joint quantitative analysis of capital structure decisions (debt versus equity) and debt structure decisions (fixed-rate debt versus floating-rate debt or inflation-linked debt) in a continuous-time setting. We show that optimizing the debt structure has an impact on capital structure decisions, and leads to increases in leverage ratios compared to a pure fixed-rate debt program. We also find that for realistic parameter values, jointly optimizing the debt and capital structures generates a significant increase in firm value with respect to a situation where only the capital structure is optimized.

Towards conditional risk parity: Improving risk budgeting techniques in changing economic environments (with Lionel Martellini and Vincent Milhau)

The Journal of Alternative Investments, 2015, 18(1), 48-64.

https://doi.org/10.3905/jai.2015.18.1.048

Abstract: Risk parity portfolios are traditionally constructed by choosing historical volatility as the risk measure. In an asset allocation context, this results in a substantial overweighting of bonds versus more volatile asset classes such as stocks: this is a concern in a low bond yield environment, since the presence of mean reversion in the yield implies that bonds are likely to perform poorly in the next future. In this article, we introduce three distinct risk parity strategies, explicitly designed to respond to changes in interest rate levels. Our results indicate that these strategies deliver higher returns when interest rates start to increase back to their long-term levels, and that the maximum Sharpe ratio portfolio, which also incorporates information on expected returns, is a less robust alternative.

Hedging inflation-linked liabilities without inflation-linked instruments through long/short investments in nominal bonds (with Lionel Martellini and Vincent Milhau)

The Journal of Fixed Income, 2015, 24(3), 5-29.

https://doi.org/10.3905/jfi.2014.24.3.005

Abstract: In the absence of inflation-linked bonds or inflation swaps, no perfect hedging strategy exists for inflation-linked liabilities, so nominal bonds are often used as substitute hedging instruments. This article provides a formal analysis of the problem of hedging inflation-linked liabilities with nominal bonds in the presence of real rate uncertainty as well as realized and expected inflation risks. Although a long-only position in nominal bonds will always have a negative exposure to unexpected inflation, the analysis suggests that long/short nominal bond portfolio strategies can in principle be designed to achieve a zero exposure to changes in unexpected inflation (required to hedge inflation-linked liabilities) while having a target exposure to changes in real rate equal to that of liabilities. The practical implementation of such long/short replication strategies, however, is not a straightforward task in the presence of parameter uncertainty. The authors explore several non-exclusive solutions to the estimation risk problem, including the use of conditional parameter estimation methodologies as well as the introduction of robust restrictions on input parameters or portfolio weights. These approaches lead to substantial improvements in out-of-sample hedging performance.

Estimation risk versus optimality risk: An ex-ante efficiency analysis of alternative equity portfolio diversification strategies (with Lionel Martellini and Vincent Milhau)

Bankers, Markets & Investors, September-October 2014, 132, 26-42.

https://ideas.repec.org/a/rbq/journl/i132p26-42.html

Abstract: Implementing portfolio optimization techniques in practice is a challenging task because of the presence of estimation risk for the required parameters, namely expected returns and covariances. This paper provides a detailed empirical analysis of the trade-off between estimation risk, i.e., the risk of imperfect estimation for the required risk and return parameters, and optimality risk, the risk induced by investing in a heuristic portfolio strategy (e.g., an equally-weighted scheme) that requires fewer or no parameter estimates. Formally, we measure the opportunity costs related to estimation risk and optimality risk as the difference in ex-ante Sharpe ratios between the true maximum Sharpe ratio portfolio and the benchmark used in practice, which is plagued by the presence of estimation risk and/or optimality risk.

Dynamic investment strategies for corporate pension funds in the presence of sponsor risk (with Lionel Martellini and Vincent Milhau)

Investments & Pensions Europe, Supplement Summer 2012, 12-14.

Abstract: This paper aims to go beyond simple forms of dynamic strategies, and to show that more sophisticated dynamic allocation strategies could usefully be implemented by pension funds. For instance, it shows that imposing a cap on the funding ratio, in addition to a floor, has a positive impact on both pensioners and bondholders, while only having a minor negative effect on equity value. The paper also introduces novel forms of dynamic strategies that recognise that pension risk is not only driven by the funding ratio of the pension fund, but also by the financial strength or weakness of the sponsor company. These strategies aim to control sponsor risk by avoiding states of the world where the pension fund is underfunded and the sponsor is unable to make up for the gap.