Working Papers
NEW
5. The Biggest Short: Duration in the Shadows - with Anthony Saunders
Presentations: BI Norwegian Business School Seminar (2024)
Abstract: We uncover a fundamental dislocation in US Treasury markets arising from the Treasury's systematic failure to internalize the economic cost of its substantial short position in duration risk. This non-internalization creates little incentive for the Treasury to strategically manage duration risk despite having access to various tools including maturity choice, floating rate notes, and interest rate swaps. The problem is amplified by a fundamental asset-liability mismatch: while tax revenues exhibit floating-rate characteristics through their correlation with economic activity, the government issues predominantly fixed-rate debt, creating an unhedged duration gap. We develop a novel framework that extends existing preferred-habitat models by explicitly incorporating the US Treasury's objective function in supplying debt alongside traditional demand-side factors and arbitrageur behavior. We model how duration and refinancing risks directly influence Treasury's debt management decisions, revealing how these institutional supply elements create persistent pricing distortions that arbitrageurs cannot eliminate beyond those explained by documented habitat factors. Our framework also captures a critical asymmetry: during QE, the Treasury benefits from remittances of coupon payments on Fed-held securities (effectively receiving "interest-free borrowing"), yet faces no corresponding penalty when rates rise and bond values decline, as the Fed absorbs these losses through deferred asset accounting. Using cross-country variation in institutional practices and Treasury bond supply quasi-experiments, we demonstrate that constrained duration risk management results in suboptimal issuance patterns and limited alternative risk transfer mechanisms. The Treasury could reduce borrowing costs by approximately 15.8 basis points through improved duration management, with benefits increasing to 22.5 basis points during stressed periods. This one-sided duration risk transfer creates asymmetric risk-return profiles in government bond markets, manifesting in systematic bond return predictability that spills over into swap markets. Our findings have important implications for Treasury debt management and financial stability amid high debt levels and rate uncertainty, as evidenced by the recent dramatic rise in long-term Treasury yields that has further magnified the economic impact of this unmanaged duration exposure.
[Updated draft]
4. From Risk-Neutral to Risk-Contaminated Expectations in Swap Markets: The Emergence of a "Hairy Premium" - with Anthony Saunders
Presentations: 2024 Annual Meetings of the American Finance Association (AFA), 2024 European Finance Association (EFA), 2024 Northern Finance Association Annual Conference (NFA), Midwest Finance Association Conference (MFA), Young Scholars Nordic Finance Network Workshop (NFN), Alpine Finance Summit, Finance and Accounting Annual Research Symposium, Financial Engineering and Banking Society, BI Workshop on Uncertainty, NYU Stern School of Business, Miami Herbert Business School, Frankfurt School of Finance and Management, and BI Norwegian Business School
Abstract: We document fundamental violations of risk-neutral no-arbitrage principles in interest rate swap markets. Standard theory assumes zero expected excess returns at swap initiation, yet 10-year swap contracts generate as much as 2.7% annual realized excess returns in U.S. markets with similar patterns across G10 currencies. We label these excess returns the "Hairy premium". We then identify the mechanism underlying the Hairy premium as the absence of long-term riskless floating instruments. This creates market incompleteness, generating multiple risk-contaminated risk-neutral derivative pricing measures that cannot be arbitraged away. Our findings challenge derivatives pricing theory with implications affecting the $640 trillion derivatives market.
[Updated draft]
3. Time-varying Market Segmentation: The Twin D’s and a Tale of Two Tails - with Sven Klingler and Lukas Kremens
(This paper subsumes the previous paper "Currency Crashes and Sovereign Defaults: Two Markets and One Tail Risk")
Presentations: AFA Annual Meeting, EEA Annual Meeting, Bank of England: 8th International Conference on Sovereign Bond Markets, Anderson School of Management Brownbag Seminar, and SDU
Abstract: This paper documents striking market segmentation between sovereign credit default swaps (CDS) and far out-of-the-money (FOM) foreign exchange (FX) options markets. Despite pricing exposure to the same fundamental tail risks - sovereign default and currency crash, the "Twin Ds" - these markets exhibit persistent pricing discrepancies that cannot be explained by differences in contract specifications or risk exposures. We propose that this segmentation reflects institutional separation between market participants: credit specialists and FX traders operate in distinct spheres with limited information sharing during normal times. Using two cross-market trading strategies - one exploiting USD-denominated CDS versus FOM FX options spreads, and another using quanto CDS versus FOM FX options - we show that these pricing discrepancies yield substantial abnormal returns with Sharpe ratios exceeding 7.2. Crucially, both strategies generate consistent results despite differing in their treatment of depreciation size upon default, confirming that our findings reflect genuine market segmentation rather than risk compensation for variable depreciation magnitude. The abnormal returns collapse to zero during sovereign crises, when information sharing intensifies and pricing converges across previously segmented markets. Our analysis further reveals that information flows unidirectionally from CDS to FX options markets, supporting our institutional explanation. We exploit regulatory changes and cross-country variation in market structure to strengthen identification and rule out alternative explanations based on rational risk pricing. These findings have implications for understanding market structure effects on tail risk pricing and for detecting potentially destabilizing market fragmentation.
[Updated draft] [Internet Appendix]
2. The Post-GFC Hedging Premium - with Olav Styrstad
(This paper merges two previous papers: "Collateral-adjusted CIP Arbitrages" and "Does Covered Interest Parity hold in long-dated securities?")
Presentations: EEA Annual Meeting, AFA Annual Meeting (Poster), Auckland Center’s Derivative Markets Conference, International Risk Management Conference, Virtual Derivatives Workshop, and Anderson School of Management Brownbag Seminar
Abstract: This study documents how post-Global Financial Crisis (GFC) market structure changes fundamentally altered derivatives pricing by creating a persistent "hedging premium" that reflects both collateralization costs and market incompleteness. While previous research documents apparent arbitrage opportunities in interest rate and cross-currency swap markets, we demonstrate these anomalies stem from the same underlying structural change: the breakdown of no-arbitrage relationships between cash and derivatives markets due to the disappearance of long-term risk-free funding and lending. Using comprehensive data on interest rate and cross-currency swaps, we show that the transition to mandatory collateralization and hedging challenges arising from market incompleteness consistently explain both medium-term and long-term deviations across markets. This unified framework accounts for both swap spreads in interest rate markets and cross-currency bases in FX markets, as derivatives pricing becomes inextricably linked to physical market frictions. Our analysis demonstrates that post-GFC derivatives pricing reflects rational compensation for structural constraints rather than unexploited arbitrage, with important implications for market efficiency, policy interventions, and risk management.
[Updated draft] [Internet Appendix] [Virtual Derivatives Workshop 2020 Presentation]
1. Constraints of Collateralization and Regulation and the Law of One Price
Awards: Macro Financial Modeling Project Fellowship Award from the Becker Friedman Institute at the University of Chicago
Summary: I research collateralisation and bank regulatory changes in the post-2008 crisis period and their ability to explain large and persistent deviations from the law of one price observed in a number of arbitrage opportunities measured by cash-derivative bases across asset classes. The study attributes the inability to narrow these arbitrage opportunites to costs of participation which arise due to intermediaries facing a collateral, leverage and liquidity constraints, resulting in limits-to-arbitrage. These constraints inhibit regulated dealers/investors’ ability to arbitrage bases across various asset classes and over time. Moreover, I go a step further and measure the magnitude of the effects of each binding constraint on the deviations from law of one price across time and in the cross section across several asset classes. This allows me to classify asset classes by the magnitude of impact received from the binding constraints. The asset class bases I look at are: Bonds-CDS, Treasuries-Interest Rate Swaps, Covered interest rate parity, Inflation rate swaps-TIPS, and Stock Index - Stock index swaps bases.
[Updated draft]
Publication of Master Thesis
Georgievska A., Georgievska, Lj, Stojanovic, A. and Todorovic, N. (2011), “Country Debt Default Probabilities in Emerging Markets: Were Credit Rating Agencies Wrong?” in Robert W.Kolb (ed.), Sovereign Debt: From Safety to Default (by invitation), Wiley, ISBN 978-0-470-92239-2
Georgievska A, Georgievska, Lj., Stojanovic, A. and N. Todorovic (2008), “Sovereign rescheduling probabilities in emerging markets: a comparison with credit rating agencies’ ratings”, Journal of Applied Statistics, 35(9), p.1031-1051
