Volatility, Valuation Ratios and Bubbles: An Empirical Measure of Market Sentiment, with Ian Martin, Journal of Finance (2021), 76:6:3211‒3254.
Sentiment Indicator Data (US Market, 1996-2019).
UK application: Bank of England underground post.
Abstract: We define a sentiment indicator based on option prices, valuation ratios, and interest rates. The indicator can be interpreted as a lower bound on the expected growth in fundamentals that a rational investor would have to perceive to be happy to hold the market. The bound was unusually high in the late 1990s, reflecting dividend growth expectations that in our view were unreasonably optimistic. Our approach exploits two key ingredients. First, we derive a new valuation ratio decomposition that is related to the Campbell and Shiller loglinearization but that resembles the Gordon growth model more closely and has certain other advantages. Second, we introduce a volatility index that provides a lower bound on the market’s expected log return.
Sveriges Riksbank, Fed NY, ECB, BoE, NBER Behavioral Finance 2019. CICF 2019, Econometric Society Asian 2019, FRIC 2019 (by CBS), Duke, LSE.
Abstract: We introduce a new measure of a government’s fiscal position that exploits cointegrating relationships among fiscal variables and output. The measure is a loglinear combination of tax revenue, government spending and the market value of government debt that—unlike the debt-GDP ratio—is stationary in the US and the UK since World War II. Fiscal deterioration forecasts a long-run decline in spending rather than increased tax revenue or low returns for bondholders. Fiscal adjustment to tax and spending shocks occurs through mean-reversion in tax and spending growth, with a negligible contribution from debt returns.
NBER Summer Institute 2023 (Asset Pricing), CBS, U of Washington, LSE, Harvard, Fulcrum Asset Management, HKUST-GZ.
Supported by Canandian Derivative Institute.
Earlier version circulated under the title: Expected currency returns and term structure of risk preferences.
Abstract: This paper challenges the prevailing notion that investors’ preferences remain independent of their investment horizon by uncovering a term structure of risk preferences. Theoretically, we extract a utility-free measure of risk preferences without temporal or horizon restrictions. Empirically, we estimate this measure using professional forecasts and expected risk premia derived from FX option prices. Our analysis of G30 currencies from 1996 to 2020 reveals that the fear of high-order risk is more pronounced in the shorter term, indicating a downward-sloping term structure of investor risk preferences. Moreover, we find that this negative slope becomes more pronounced during adverse times but shifts to an upward slope during favorable periods. These insights offer valuable guidance for enriching existing asset pricing models with horizon-dependent risk preferences, shedding new light on the dynamics of risk premia across different time horizons.
RAPS conference (CUHK) 2023, Bank of Canada, HKU, ICEEE 2023, QRFE Asset Pricing Workshop (Durham U) 2023, U of Laval, HEC Montreal, Fulcrum Asset Management, VSFX 2022, Doctoral Consortium of the Asian Finance Association 2022, LIF-SAFE Frankfurt, HSG, UNSW.
Betting Against Correlations: A Measure of Global Market Risk, with Paul Schneider.
Abstract: We measure the systemic risk of FX exchange rates by relating the joint distribution of exchange rates to a distribution that assumes independence. A sharp upper bound of the distance between those two can be constructed through a quadratic portfolio problem where the representative agent bets against correlations among exchange rates. Using forward looking information from the cross-section of option prices and consensus forecasts, we are able to compute the systemic foreign exchange risk in real time, and to investigate it in a broader macroeconomic context.
Cancun Derivative Workshop 2022, Swiss Finance Institute research day 2022.
Heterogeneous Beliefs on N Tree, with Brandon Yueyang Han.
Abstract: We solve a discrete time multi-nomial tree model featuring risk averse agents with heterogeneous beliefs. The disagreement agents have on the probability distribution of the state of world makes agents' portfolio choice, asset prices and the aggregate sentiment path dependent. In a Brownian continuous time limit, the Black-Scholes formula of option price presents a volatility smile that could be explained by agents' disagreement on volatility.
Abstract: We study the long-horizon risk profile of a currency strategy, whereby a US investor earns excess returns by entering in an unhedged long position in a foreign long-term bond funded at the domestic risk-free rate. After showing the drivers of the strategy returns, we derive and estimate their long-horizon predictive variance using data on long-term bonds denominated in major currencies over the past two centuries. We find that the long-horizon risk of such strategies increases with the investment horizon and that it is mainly driven by the uncertainty associated with the predictions of future returns originating from interest rate differentials and exchange rate returns.
ABFER 2022; BoE; Workshop on Bayesians in Finance, Singapore 2018; Belgrade Symposium in Economics and Finance 2018.