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ORCiD https://orcid.org/0000-0001-5867-927X

Publications

Pricing Risks across Currency Denominations - Management Science, 2019, 65(11), 5308-5336.

(with Thuy-Duong To and Ngoc-Khanh Tran)

Abstract: We use principal component analysis on 55 bilateral exchange rates of 11 developed currencies to identify two important global risk sources in FX markets. The risk sources are related to Carry and Dollar but are not spanned by these factors. We estimate the market prices associated with the two risk sources in the cross-section of FX market returns and construct FX market implied country-specific SDFs. The SDF volatilities are related to interest rates and expected carry trade returns in the cross-section. The SDFs price international stock returns and are related to important financial stress indicators and macroeconomic fundamentals. The first principal risk is associated with the TED spread, quantities measuring volatility, tail and contagion risks and future economic growth. It earns a relatively small implied Sharpe ratio. The second principal risk is associated with the default and term spreads and quantities capturing volatility and illiquidity risks. It further correlates with future changes in the long term interest rate and earns a large implied Sharpe ratio. 

Entangled Risks in Incomplete FX Markets - Journal of Financial Economics, 2021, 142(1), 146-165.

(with Ngoc-Khanh Tran)

Abstract: We introduce the concept of risk entanglement in a preference-free setting to jointly explain the exchange rate volatility, cyclicality, and currency risk premia in the data. Risk entanglement specifies a subset of incomplete market models, in which non-diffusive or non-log-normal shocks to exchange rates are not fully spanned by asset returns. When risks are entangled there exist multiple pricing-consistent exchange rates, but none of them are equal to the ratio of the stochastic discount factors (SDFs) or their projections. Decoupling the exchange rate from the SDFs allows us to address key FX market patterns that are puzzling in international finance.

Pricing Implications of Covariances and Spreads in Currency Markets - Review of Asset Pricing Studies, 2022, 12(1), 336-388.

(with Thuy-Duong To and Ngoc-Khanh Tran)

Abstract: We introduce a covariance and spread (i.e., exchange rate forward discount) adjusted carry factor that prices the cross-section of FX market returns, where many other single and multi-factor models fail. Both the covariance matrix of exchange rate growths and forward discounts contain important information for pricing, which is not captured by well-known factors. The conditional covariance matrix and forward discounts are time-varying and forecast future realized currency returns. 

Market Timing and Predictability in FX Markets - Review of Finance, 2023, 27(1), 223-246.

(with Thuy-Duong To and Ngoc-Khanh Tran)

Abstract: We study the economic value of market timing in FX markets, i.e., using information about the conditional Sharpe ratio to adjust the notional value of a conditionally mean-variance efficient currency portfolio. Our strategy trades more (less) aggressively when the conditional risk-return trade-off is more (less) favorable. This leads to a significant improvement in the out-of-sample unconditional Sharpe ratio, skewness and maximum drawdown per 1% expected excess return. The strategy's market timing predicts returns, volatility and skewness in FX markets. Popular currency pricing factors do not explain the strategy's high average excess returns. Our findings suggest that it is costly to impose leverage or risk (i.e., conditional volatility) limits or other inferior market timing policies when constructing currency trading strategies. 

Reproducibility in Management Science - Management Science, forthcoming.

(as part of the Management Science Reproducibility Collaboration under the lead of Miloš Fišar, Ben Greiner, Christoph Huber, Elena Katok, Ali Ozkes)

Abstract: With the help of more than 700 reviewers we assess the reproducibility of nearly 500 articles published in the journal Management Science before and after the introduction of a new Data and Code Disclosure policy in 2019. When considering only articles for which data accessibility and hard- and software requirements were not an obstacle for reviewers, the results of more than 95% of articles under the new disclosure policy could be fully or largely computationally reproduced. However, for 29% of articles at least part of the dataset was not accessible to the reviewer. Considering all articles in our sample reduces the share of reproduced articles to 68%. These figures represent a significant increase compared to the period before the introduction of the disclosure policy, where only 12% of articles voluntarily provided replication materials, out of which 55% could be (largely) reproduced. Substantial heterogeneity in reproducibility rates across different fields is mainly driven by differences in dataset accessibility. Other reasons for unsuccessful reproduction attempts include missing code, unresolvable code errors, weak or missing documentation, but also soft- and hardware requirements and code complexity. Our findings highlight the importance of journal code and data disclosure policies, and suggest potential avenues for enhancing their effectiveness. 

Importance of Transaction Costs for Asset Allocation in Foreign Exchange Markets - Journal of Financial Economics, accepted.

(with Ilias Filippou, Luca Pezzo and Mark P. Taylor)

Data: Bid-Ask, Amihud for 26 FX rates; Before & After Cost Portfolio Returns, 1986-2024 

Abstract: Transaction costs have a first-order effect on the performance of currency portfolios. When a fund is large, costs due to the price impact of trading quickly erode returns, leaving many popular strategies unprofitable. A mean-variance approach that accounts for transaction costs in the optimization (MVTC) efficiently tackles the problem with only relatively minor negative implications on before-cost profitability. MVTC is robust even when the price impact of trading is severe. In contrast, popular rules-of-thumb to mitigate costs are inefficient as there are unintended, adverse effects on before-cost performance that dominate the intended cost savings. Finally, we introduce an accurate extrapolation approach to expand the sample of the realized Amihud measure of Ranaldo and Santucci de Magistris (2022) from 12 to 26 currencies and from 2012 back in time to 1986.

Working Papers

Dollar and Carry Redux

(with Sining Liu, Andrea Vedolin and Yaoyuan Zhang)

Abstract: Contrary to existing literature, we establish that two factors, dollar and carry, suffice to explain a large cross-section of currency returns with R2s exceeding 80%. Our paper highlights the importance of accounting for time-variation in conditional moments. Unconditional estimations that ignore this time-variation mistakenly reject the two-factor model. We propose a parsimonious framework to estimate conditional currency factor models and provide testable restrictions. Our findings imply that currency markets are well described by a model in which (i) each country-specific SDF loads on one country-specific—dollar—and one global—carry shock, and (ii) risk loadings are time-varying. Other risk factors proposed in the literature are useful to describe the time variation in dollar and carry factor risk premia.

Unfair Benchmarks and Excessive Risk Taking of Mutual Funds

(with Sanghyun Hugh Kim)

Abstract: We find that unfair peer group assignments in relative performance evaluations often lead mutual funds with disadvantaged styles to take on more risks in an effort to keep up with their peers with advantaged styles. Until June 2002, when Morningstar ranked all U.S. equity funds against one another, star ratings were highly correlated with the value premium, leading growth funds to take significantly greater risks than value funds. This excessive risk-taking was more pronounced among lower-rated funds and when the value premium was expected to be higher. The refinement of Morningstar's peer groups in 2002 substantially reduced such excessive risk-taking. 

Kyle goes International: Asymmetric Information and Strategic Trading in the Foreign Exchange Triangle

(with Matteo Pantalfini)

Abstract: We extend the Kyle (1985) model to the FX triangle of currencies, with information asymmetry between one informed risk-averse speculator and three uninformed risk-neutral dealers. Each dealer specializes in a market for one currency pair. In equilibrium, the speculator trades on a currency pair’s private information directly in the corresponding market as well as indirectly via a vehicle currency (i.e., simultaneously in the other two markets). Each dealer only observes the total order of the speculator for the currency pair in her market, and she cannot decompose the order into direct trading, indirect trading, and exogenous noise trading. From a dealer’s perspective indirect trading endogenously generates noise in addition to the exogenous noise trading. Accordingly, the speculator strategically trades indirectly to deceive the dealers. The optimal trading position for a currency pair depends not only on the liquidity in the specific market but also the liquidity in the other two markets. Our model has important implications for the interconnectedness of liquidity across currency markets.

The Collateral Value of Housing: Evidence from Servicemember Pension Choice

(with Benjamin Bennett and Radha Gopalan)

Abstract: We evaluate the effect of house prices on U.S. military servicemember pension choices. In our setting the wealth channel – an increase in house prices increases household wealth and both current and future consumption – and the collateral channel – an increase in house prices enables the household to borrow more using housing collateral – have contrasting predictions about servicemember choices. Using state-level land supply inelasticity as an instrument for house price changes, we find that consistent with the collateral channel (and inconsistent with the wealth channel) servicemembers from states that experience house price increases are less likely to choose the pension option that provides immediate liquidity at the expense of long-term benefits. A one standard deviation increase in house prices translates into a reduction in the servicemember’s implied discount rate from 8% (the average borrowing rate against future pension in our sample) to 6.3%. 

Pricing Shocks to Conditional Market Beta

(with Bo Tang)

Abstract: Following Bali (2008) we estimate conditional market beta of 10 momentum and 25 size and book-to-market portfolios using a multivariate GARCH model. Conditional market beta determine expected returns and covariances of assets. Therefore, shocks to conditional market beta are shocks to the investment opportunity set, and are priced state variables in the ICAPM. We find that shocks to conditional market beta carry significant risk premia. We further document a striking relationship between shocks to conditional market beta and the Fama-French-Carhart (FFC) size, book-to-market and momentum factors. Our findings provide an economic interpretation for the FFC factors as ICAPM state variables. 

Incomplete Asset Market View of the Exchange Rate Determination

(with Ngoc-Khanh Tran)

Abstract: We completely characterize the fundamental relationship between the exchange rate and the asset pricing in the two denomination currencies involved when markets are incomplete. Assuming arbitrage-free, perfectly integrated, frictionless but potentially incomplete financial markets, the exchange rate is equal to the ratio of countries' minimum-variance stochastic discount factors if and only if every exchange rate risk can be separately contracted in asset markets, i.e., exchange rate risks are completely disentangled. Abstracting from structural assumptions, the entanglement of exchange rate risks presents a novel and pure market-based rationale for a disconnection between prices and quantities in the international economy. Our study demonstrates when and how the influential asset market view of the exchange rate does not pose strong implications from the exchange rate dynamics on the macroeconomic fundamentals and their pricing.

The Hirshleifer Effect in a Dynamic Setting

(with Ngoc-Khanh Tran)

Abstract: We analyze the value of public information in a competitive endowment economy with multiple consumption and trading dates. We provide a global result that early information releases are desired by all agents if they disagree about the prospect of the economy and asset mar- kets are complete. Moreover, under disagreements such that agents anticipate modest benefits from risk sharing and sufficiently large benefits from intertemporal consumption smoothing, all agents strictly prefer an early release of information even if they cannot trade in asset markets before the information arrives. Therefore, the well-known Hirshleifer effect reverses in these circumstances. 

Public Information and Risk-Sharing in a Pure-Exchange Economy

(with Ngoc-Khanh Tran)

Abstract: We analyze whether the timing of public information releases affects risk-sharing and pricing in a pure exchange economy. Information releases do not matter if agents have time additive preferences, homogeneous beliefs and access to complete markets. In the case of heterogeneity in agents' beliefs, we are able to show analytically that early information releases are Pareto improving but pricing is essentially unaffected. In the case of recursive preferences we provide numerical results suggesting that early information releases improve risk-sharing, and if the EIS is large enough, they have a negative effect on the ex-ante equity premium.

Is Consumption Growth merely a Sideshow in Asset Pricing?

Abstract: I study a parsimonious model of a time-varying market risk premium. State pricing is dominated by time preference shocks that may be independent of the consumption process. The model resolves several asset pricing puzzles and provides predictions for how the risk premium varies with measurable financial quantities like the price-earnings ratio and interest rates. Time preference shocks can generate a low level and volatility in the real interest rate and a high stock price volatility and equity premium. The price-earnings ratio has power to predict future stock returns and reveals information about unobservable financial quantities.

Asset Pricing Implications of Demographic Change

Abstract: I solve an overlapping generations model with stochastic birth and death rates in general equilibrium. I provide sufficient conditions so that the interest rate is decreasing in the birth and increasing in the death rate. If preferences are non-time-separable, stochastic changes in birth and death rates are priced in financial markets and the equity premium is increasing in the birth and decreasing in the death rate. Demographic changes generate a positive and sizable bond term premium and time series variation in the interest rate and equity premium. Using a balanced panel of 18 countries from 1981 to 2011, I document that the qualitative results in the model are consistent with the data.

Time Variation in Life Expectancy, Optimal Portfolio Choice and the Cross-Section of Asset Returns

Abstract: I solve a portfolio optimization problem with stochastic death rates. An agent demands more of an asset that pays off high (low) in states of the world when he expects to live longer (shorter) than an asset with the opposite payoff. Consequently, in equilibrium, an asset with a positive correlation between its returns and changes in the life expectancy pays a lower expected return than an asset with a negative correlation. Empirical evidence supports the model. Out-of-sample evidence suggests that a trading strategy, which exploits the theoretical relationship, pays 3.25% annual unexplained returns according to the CAPM.

Cointegration in Finance: An Application to Index Tracking

Abstract: The purpose of this paper is to construct and test two different index tracking strategies - one based upon cointegration analysis of the price processes of assets (CIT strategy), and the other based on a market equilibrium and continuous time portfolio optimisation approach (MIT strategy). Within a broad empirical analysis it is found that both tracking strategies are able to track an index (FTSE100, DJ Industrial, DJ Composite Average) accurately, even if only a relatively small subset of constituent stocks is used. Thereby, it is also suggested that (particularly in the British stock market) the CIT strategy is preferred since there is some (out of sample) evidence indicating that log-price spreads between index and CIT tracking portfolio follow a stationary process. Moreover, regarding the attempt to perform simple enhanced indexation, no empirical evidence was found that would suggest that either of the two tracking strategies was suitable for such an approach.