http://hdl.handle.net/2451/25931 Search the Channel search http://archive.nyu.edu/simple-search http://hdl.handle.net/2451/26905 http://hdl.handle.net/2451/26881 Title: WHAT GOOD IS A VOLATILITY MODEL?<br/><br/>Engle, Robert F.; Patton, Andrew J.<br/><br/>Abstract: A volatility model must be able to forecast volatility; this is thecentral requirement in almost all financial applications. In this paperwe outline some stylised facts about volatility that should beincorporated in a model; pronounced persistence and meanreversion,asymmetry such that the sign of an innovation also affects volatilityand the possibility of exogenous or pre-determined variables influencingvolatility. We use data on the Dow Jones Industrial index to illustratethese stylised facts, and the ability of GARCH-type models to capturethese features. We conclude with some challenges for future research inthis area. http://hdl.handle.net/2451/26892 Title: Theoretical and Empirical Properties of Dynamic Conditional CorrelationMultivariate GARCH<br/><br/>Engle, Robert F.; Sheppard, Kevin<br/><br/>Abstract: In this paper, we develop the theoretical and empirical properties of anew class of multivariate GARCH models capable of estimating largetime-varying covariance matrices, Dynamic Conditional CorrelationMultivariate GARCH. We show that the problem of multivariate conditionalvariance estimation can be simplified by estimating univariate GARCHmodels for each asset, and then, using transformed residuals resultingfrom the first stage, estimating a conditional correlation estimator.The standard errors for the first stage parameters remain consistent,and only the standard errors for the correlation parameters need to bemodified. We use the model to estimate the conditional covariance of upto 100 assets using S&amp;P 500 Sector Indices and Dow Jones IndustrialAverage stocks, and conduct specification tests of the estimator usingan industry standard benchmark for volatility models. This new estimatordemonstrates very strong performance especially considering ease ofimplementation of the estimator. http://hdl.handle.net/2451/26899 Title: The Valuation of Caps, Floors and Swaptions in a Multi-Factor Spot-Rate Model<br/><br/>Peterson, Sandra; Stapleton, Richard C.; Subrahmanyam, Marti G.<br/><br/>Abstract: We build a multi-factor, no-arbitrage model of the term structure ofspot interest rates. The stochastic factors are the short-term interestrate and the premia of the futures rates over the short-term interestrates. In the three-factor version of the model, for example, the firstfactor is the three-month LIBOR, the second factor is the premium of thefirst futures LIBOR over spot LIBOR, and the third factor is theincremental premium of the second futures over the first. The modelprovides an extension of the lognormal interest rate model of Black andKarasinski (1991) to multiple factors, each of which can exhibitmean-reversion. This method is computationally efficient for severalreasons. First, we suggest calibrating the model to LIBOR futuresprices, which enables us to satisfy the no-arbitrage condition withoutresorting to iterative methods. Second, we modify and implement thebinomial approximation methodology of Nelson and Ramaswamy (1990) andHo, Stapleton and Subrahmanyam (1995) to compute a multi-period tree ofrates with the no-arbitrage property. The method uses a recombining twoor three-dimensional binomial lattice of interest rates that minimizesthe number of states and term structures over time. In addition to thesecomputational advantages, a key feature of the model is that it isconsistent with the observed term structure of futures rates as well asthe term structure of volatilities implied by the prices of interestrate caps and floors. We use the model to price European-style andBermuda-style swaptions and yield-spread options. To implement themethodology, we first calibrate the model to the capletimplied-volatility curve on a given day, and then use the model to priceEuropean-style swaptions. We find that the two-factor model, where theLIBOR mean reverts rapidly to a slowly mean-reverting second factor,overprices the swaptions relative to market quotations. However,introducing a third factor significantly reduces the overpricing. Thecalibrated model is used to price Bermudan-style swaptions andyield-spread options. Then, we re-calibrated the two-factor modelsimultaneously to caplet and swaption prices and use the model output toprice Bermudan-style swaptions. http://hdl.handle.net/2451/26800 Title: The Underlying Dynamics of Credit Correlations<br/><br/>Berd, Arthur; Engle, Robert; Voronov, Artem<br/><br/>Abstract: We propose a hybrid model of portfolio credit risk where the dynamics ofthe underlying latent variables is governed by a one factor GARCHprocess. The distinctive feature of such processes is that the long-termaggregate return distributions can substantially deviate from theasymptotic Gaussian limit for very long horizons. We introduce thenotion of correlation spectrum as a convenient tool for comparingportfolio credit loss generating models and pricing synthetic CDOtranches. Analyzing alternative specifications of the underlyingdynamics, we conclude that the asymmetric models with TARCH volatilityspecification are the preferred choice for generating significant andpersistent credit correlation skews. http://hdl.handle.net/2451/26893 Title: The Term Structure of Interest-Rate Futures Prices.<br/><br/>Stapleton, Richard C.; Subrahmanyam, Marti G.<br/><br/>Abstract: We derive general properties of two-factor models of the term structureof interest rates and, in particular, the process for futures prices andrates. Then, as a special case, we derive a no-arbitrage model of theterm structure in which any two futures rates act as factors. The termstructure shifts and tilts as the factor rates vary. The cross-sectionalproperties of the model derive from the solution of a two dimensionalautoregressive process for the short-term rate, which exhibits both meanreversion and a lagged persistence parameter. We show that thecorrelation of the futures rates is restricted by the no-arbitrageconditions of the model. In addition, we investigate the determinants ofthe volatility of the futures rates of various maturities. These areshown to be related to the volatilities of the short rate, thevolatility of the second factor, the degree of mean reversion and thepersistence of the second factor shock. We obtain specific results forfutures rates in the case where the logarithm of the short-term rate[e.g., the London Inter-Bank Offer Rate (Libor)] follows atwo-dimensional process. Our results lead to empirical hypotheses thatare testable using data from the liquid market for Eurocurrency interestrate futures contracts. http://hdl.handle.net/2451/26803 Title: The Rise in Firm-Level Volatility: Causes and Consequences<br/><br/>Comin, Diego; Philippon, Thomas<br/><br/>Abstract: We document that the recent decline in aggregate volatility has beenaccompanied by a large increase in firm level risk. The negativerelationship between firm and aggregate risk seems to be present acrossindustries in the US, and across OECD countries. Firm volatilityincreases after deregulation. Firm volatility is linked to research anddevelopment spending as well as access to external financing. Further,R&amp;D intensity is also associated with lower correlation of sectoralgrowth with the rest of the economy. http://hdl.handle.net/2451/26802 Title: The Promise and Peril of Real Options<br/><br/>Damodaran, Aswath<br/><br/>Abstract: In recent years, practitioners and academics have made the argument thattraditional discounted cash flow models do a poor job of capturing thevalue of the options embedded in many corporate actions. They have notedthat these options need to be not only considered explicitly and valued,but also that the value of these options can be substantial. In fact,many investments and acquisitions that would not be justifiableotherwise will be value enhancing, if the options embedded in them areconsidered. In this paper, we examine the merits of this argument. Whileit is certainly true that there are options embedded in many actions, weconsider the conditions that have to be met for these options to havevalue. We also develop a series of applied examples, where we attempt tovalue these options and consider the effect on investment, financing andvaluation decisions. http://hdl.handle.net/2451/26878 Title: THE OPERATIONAL HEDGING PROPERTIES OF INTANGIBLE ASSETS: THE CASE OFNON-VOLUNTARY FOREIGN ASSET SELLOFFS<br/><br/>Doukas, John A.; Padmanabhan, Prasad<br/><br/>Abstract: In this paper we examine the valuation effects and long-term performanceof U.S. multinational firms involved in forced transfers of theirforeign operating assets during the 1965-1988 period. The evidencesuggests that the operational hedging ability of the firm to addresscountry risk (nationalization threats) is related to the level of itsintangible assets. While it is well known that firms with high levels ofintangible assets prefer foreign direct investment, our results showthat intangible assets have hidden properties of protection againstcountry risk as well. We document significantly negative abnormalreturns only for divesting firms with low levels of intangible assets,but not for firms with high levels of intangible assets. In addition, weshow that low (high) growth firms are involved in partial (complete)withdrawals, and show that the long-term economic performance of firmschoosing the complete withdrawal strategy is better than those that optto remain. We argue that management's attempt to maintain economic linksin a hostile foreign environment can be attributed in part to the firm'slow growth opportunities, performance, and lack of contingent plans toaddress country risk. http://hdl.handle.net/2451/26824 Title: The Long-Run Behavior of Debt and Equity Underwriting Spreads<br/><br/>Kim, Dongcheol; Palia, Darius; Saunders, Anthony<br/><br/>Abstract: This paper is the first to look at the long-run (30-year) behavior ofunderwriting spreads in the markets for corporate equity and debt.Specifically, we analyze the determinants of underwriting spreads oncorporate bond issues, secondary equity offerings and initial publicofferings over the period 1970-2000. We explain the time-varyingcross-sectional behavior of these spreads by analyzing three sets ofvariables or factors: macro (systematic) factors, investment bankingmarket structure factors and issuer specific characteristics. We alsoanalyze the relationship between the direct costs (underwriting spreads)and indirect costs (underpricing) of new issues. Among our many resultswe find an apparent decline in spreads over time, an increasedclustering in spreads for both IPOs and SEOs, the dominance of issuer-specific characteristics in explaining spreads, and a relatively weaklinkeage between the direct and indirect costs of issuance. http://hdl.handle.net/2451/26818 Title: The Link between Default and Recovery Rates: Theory, Empirical Evidenceand Implications<br/><br/>Altman, Edward I.; Brady, Brooks; Resti, Andrea; Sironi, Andrea<br/><br/>Abstract: This paper analyzes the association between aggregate default andrecovery rates on credit assets, and seeks to empirically explain thiscritical relationship. We examine recovery rates on corporate bonddefaults, over the period 1982-2002. Our econometric univariate andmultivariate models explain a significant portion of the variance inbond recovery rates aggregated across all seniority and collaterallevels. The central thesis is that aggregate recovery rates arebasically a function of supply and demand for the securities, withdefault rates playing a pivotal role. Such a link would bring about asignificant increase in both expected and unexpected losses as measuredby some widespread credit risk models, and would affect theprocyclicality effects of the New Basel Capital Accord. Our results havealso important implications for investors in corporate bonds and bankloans, and for all markets (e.g., securitizations, credit derivatives,etc.) which depend on recovery rates as a key variable. http://hdl.handle.net/2451/27381 Title: The Information in Long-Maturity Forward Rates: Implications forExchange Rates and the Forward Premium Anomaly<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Whitelaw, Robert F.<br/><br/>Abstract: The forward premium anomaly is one of the most robust puzzles infinancial economics. We recast the underlying parity relation in termsof cross-country differences between forward interest rates rather thanspot interest rates with dramatic results. These forward interest ratedifferentials have statistically and economically significant forecastpower for annual exchange rate movements, both in- and out-of-sample,and the signs and magnitudes of the corresponding coefficients areconsistent with economic theory. Forward interest rates also forecastfuture spot interest rates and future inflation. Thus, we attribute muchof the forward premium anomaly to the anomalous behavior of shortterminterest rates, not to a breakdown of the link between fundamentals andexchange rates. http://hdl.handle.net/2451/27382 Title: The Information in Long-Maturity Forward Rates: Implications forExchange Rates and the Forward Premium Anomaly<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Whitelaw, Robert F.<br/><br/>Abstract: The forward premium anomaly is one of the most robust puzzles infinancial economics. We recast the underlying parity relation in termsof cross-country differences between forward interest rates rather thanspot interest rates with dramatic results. These forward interest ratedifferentials have statistically and economically significant forecastpower for annual exchange rate movements, both in- and out-of-sample,and the signs and magnitudes of the corresponding coefficients areconsistent with economic theory. Forward interest rates also forecastfuture spot interest rates and future inflation. Thus, we attribute muchof the forward premium anomaly to the anomalous behavior of shortterminterest rates, not to a breakdown of the link between fundamentals andexchange rates. http://hdl.handle.net/2451/26793 Title: The Determinants of Liquidity in the Corporate Bond Markets: AnApplication of Latent Liquidity<br/><br/>Chacko, George; Mahanti, Sriketan; Mallik, Gaurav; Subrahmanyam, Marti<br/><br/>Abstract: We present a new measure of liquidity known as &ldquo;latentliquidity&rdquo; and apply it to a unique corporate bond database todiscern the characteristics of bonds that lead to higher liquidity.Unlike conventional measures of liquidity, such as trading volume andbid-ask spreads, our measure of liquidity does not use transactionalinformation; instead, it uses information about the ownership ofsecurities to measure the accessibility of a security by a securitiesdealer. Therefore, our measure has the important advantage of being ableto assess liquidity for markets with extremely low trading activity,where transactions data are insufficient to compute traditional measuresof liquidity, but where liquidity is still an important issue. We relateour proposed latent liquidity measure to bond characteristics such asamount outstanding, credit quality, maturity, age, optionality andindustry segment. In the liquid segments of the market, wheretrade-based measures of liquidity are available, our proposed measureexhibits similar relationships to bond characteristics as thetrade-based measures. However, latent liquidity exhibits greaterconsistency in terms of its relationships with bond characteristics,over time. In addition, in the illiquid segment of the market, therelationships of our measure to bond characteristics are also similar towhat we observe in the liquid segment. This leads us to believe that ourmeasure is a viable measure of liquidity, when trade-based measures are unavailable http://hdl.handle.net/2451/26826 Title: The Cash Flow, Return and Risk Characteristics of Private Equity<br/><br/>Ljungqvist, Alexander; Richardson, Matthew<br/><br/>Abstract: Using a unique dataset of private equity funds over the last twodecades, this paper analyzes the cash flow, return, and riskcharacteristics of private equity. Unlike previous studies, we havedetailed cash flow data for each fund, rather than aggregate oraccounting returns. We also know the exact timing of investments andcapital returns to investors and the number and types of companies eachfund invested in. We document the draw down and capital return schedulesfor the typical private equity fund, and show that it takes severalyears for capital to be invested, and over ten years for capital to bereturned to generate excess returns. We provide several determiningfactors for these schedules, including existing investment opportunitiesand competition amongst private equity funds. In terms of performance,we document that private equity generates excess returns on the order offive to eight percent per annum relative to the aggregate public equitymarket. Moreover, while we estimate the betas of the private equityfunds&rsquo; portfolios to be greater than one, we show that on arisk-adjusted basis the excess value of the typical private equity fundis on the order of 24 percent relative to the present value of theinvested capital. One interpretation of this magnitude is that itrepresents compensation for holding a 10-year illiquid investment. http://hdl.handle.net/2451/26876 Title: Term Structure Dynamics in Theory and Reality<br/><br/>Dai, Qiang; Singleton, Kenneth<br/><br/>Abstract: This paper is a critical survey of models designed for pricing fixedincome securities and their associated term structures of market yields.Our primary focus is on the interplay between the theoreticalspecification of dynamic term structure models and their empirical fitto historical changes in the shapes of yield curves. We begin byoverviewing the dynamic term structure models that have been fit totreasury or swap yield curves and in which the risk factors followdiffusions, jump-diffusion, or have \switching regimes.&quot; Then thegoodness-of- ts of these models are assessed relative to their abilitiesto: (i) match linear projections of changes in yields onto the slope ofthe yield curve; (ii) match the persistence of conditional volatilities,and the shapes of term structures of unconditional volatilities, ofyields; and (iii) to reliably price caps, swaptions, and otherfixed-income derivatives. For the case of defaultable securities weexplore the relative fits to historical yield spreads. http://hdl.handle.net/2451/26887 Title: Spiders: Where are the Bugs?<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Comer, George; Li, Kai http://hdl.handle.net/2451/26817 Title: Specification Analysis of Option Pricing Models Based on Time-ChangedLevy Processes<br/><br/>Huang, Jing-zhi; Wu, Liuren<br/><br/>Abstract: We analyze the specifications of option pricing models based ontime-changed Levy processes. We classify option pricing models based onthe structure of the jump component in the underlying return process,the source of stochastic volatility, and the specification of thevolatility process itself. Our estimation of a variety of modelspecifications indicates that to better capture the behavior of theS&amp;P 500 index options, we must incorporate a high frequency jumpcomponent in the return process and generate stochastic volatilitiesfrom two different sources, the jump component and the diffusion component. http://hdl.handle.net/2451/26895 Title: Risk Management with Derivatives by Dealers and Market Quality inGovernment Bond Markets<br/><br/>Naik, Narayan Y.; Yadav, Pradeep K.<br/><br/>Abstract: This paper examines how bond dealers use futures markets to manage thehedgeable market risk component of their core business risk exposure,and whether market quality is adversely affected by their selective risktaking activity. It also investigates the efficiency of market risksharing within a decentralized semi-transparent market structure. Wefind that dealers engage in duration targeting, behaving as if they havea comparative advantage in bearing interest rate risk. They makesignificant directional bets often by holding futures that are in thesame direction as the spot. They actively use futures to hedge changesin the spot exposure. They hedge changes in their spot exposure morewhen the potential costs of regulatory distress are high, when the costof such hedging is low, and during periods of greater uncertainty. Wefind that duration targeting by dealers has adverse price effects due tocapital constraints as predicted by Froot and Stein (1998). Finally, wefind that trades in the spot market are not executed by dealers withextreme exposures. In this context, we recommend market reforms such asintroduction of central quote posting or limit order book that willenable more efficient matching of liquidity demanders and suppliers,reduce trading costs, and improve the quality of risk sharing. http://hdl.handle.net/2451/26903 Title: Risk Management with Benchmarking<br/><br/>Basak, Suleyman; Shapiro, Alex; Tepla, Lucie<br/><br/>Abstract: Portfolio theory must address the fact that in reality, portfoliomanagers are evaluated relative to a benchmark, and therefore adopt riskmanagement practices to account for the benchmark performance. Wecapture this risk management consideration by allowing a prespecifiedshortfall from a target benchmark-linked return, consistent with growinginterest in such practice. In a dynamic setting, we demonstrate how arisk averse portfolio manager optimally under- or overperforms a targetbenchmark under different economic conditions, depending on his attitudetowards risk and choice of the benchmark. Investors can thereforeachieve their desired gain/loss characteristics for funds undermanagement through an appropriate combined choice of the benchmark andmoney manager. http://hdl.handle.net/2451/26828 Title: Regime-Switching and the Estimation of Multifractal Processes<br/><br/>Calvet, Laurent; Fisher, Adlai<br/><br/>Abstract: We propose a discrete-time stochastic volatility model in whichregime-switching serves three purposes. First, changes in regimescapture low frequency variations, which is their traditional role.Second, they specify intermediate frequency dynamics that are usuallyassigned to smooth autoregressive processes. Finally, high frequencyswitches generate substantial outliers. Thus, a single mechanismcaptures three important features of the data that are typicallyaddressed as distinct phenomena in the literature. Maximum likelihoodestimation is developed and shown to perform well in finite sample. Weestimate on exchange rate data a version of the process with fourparameters and more than a thousand states. The estimated model comparesfavor-ably to earlier specifications both in- and out-of-sample.Multifractal forecasts slightly improve on GARCH(1,1) at daily andweekly inter-vals, and provide considerable gains in accuracy athorizons of 10 to 50 days. http://hdl.handle.net/2451/26813 Title: Regime Shifts in a Dynamic Term Structure Model of U.S. Treasury Bond Yields<br/><br/>Dai, Qiang; Singleton, Kenneth J.; Yang, Wei<br/><br/>Abstract: This paper develops and empirically implements an arbitrage-free,dynamic term structure model with &quot;priced&quot; factor andregime-shift risks. The risk factors are assumed to follow adiscrete-time Gaussian process, and regime shifts are governed by adiscrete-time Markov process with state-dependent transitionprobabilities. This model gives closed-form solutions for zero-couponbond prices and an analytic representation of the likelihood functionfor bond yields. Using monthly data on U.S. Treasury zero-coupon bondyields, we document notable differences in the behaviors of the marketprices of factor risk across high and low volatility regimes.Additionally, the state-dependence of the regime-switching probabilitiesis shown to capture an interesting asymmetry in the cyclical behavior ofinterest rates. The shapes of the term structures of bond yieldvolatilities are also very different across regimes, with the well-knownhump in volatility being largely a low-volatility regime phenomenon. http://hdl.handle.net/2451/26829 Title: Pricing Inflation-Indexed Convertible Bonds with Credit Risk<br/><br/>Landskroner, Yoram; Raviv, Alon<br/><br/>Abstract: In Issuing convertible bonds has become a popular way of raising capitalby corporations in the last few years. An important subgroup isconvertibles linked to a price index or exchange rate. The valuationmodel of inflation-indexed (or equivalently foreign-currency)convertible bonds derived in this paper considers two sources ofuncertainty allowing both the underlying stock and theconsumer-price-index to be stochastic and incorporates credit risk inthe analysis. We approximate the pricing equations by using a Rubinstein(1994) three-dimensional binomial tree, and we describe the numericalsolution. We investigate the sensitivity of the theoretical values withrespect to the characteristics of the issuer, the economic environmentand the security&rsquo;s characteristics (number of principal payments).Moreover, we demonstrate the usefulness and the limitations of thepricing model by using inflation-indexed and foreign-currency linkedconvertibles traded on the Tel- Aviv stock exchange. http://hdl.handle.net/2451/26827 Title: PRICING EXCHANGE TRADED FUNDS<br/><br/>Engle, Robert; Sarkar, Debojyoti<br/><br/>Abstract: Exchange Traded Funds are equity issues of companies whose assetsconsist entirely of cash and shares of stock approximating particularindexes. These companies resemble closed end funds except for the uniquefeature that additional shares can be created or redeemed by a number ofregistered entities. This paper investigates the extent and propertiesof the resulting premiums and discounts of ETFs from their fair marketvalue. Measured premiums and discounts can be misleading because thenet asset value of the portfolio is not accurately represented orbecause the price of the fund is not accurately recorded. These featuresare incorporated into a model with errors-in-variables that accounts forthese effects and measures the standard deviation of the remainingpricing errors. Time variation in this standard deviation isinvestigated. Both domestic and international ETFs are examined, eachfrom an end-of-day perspective and from a minute-by-minute intra-dailyframework. The overall finding is that the premiums/discounts for thedomestic ETFs are generally small and highly transient, once mismatchesin timing are accounted for. Large premiums typically last only severalminutes. The standard deviation of the premiums/discount is 15 basispoints on average across all ETFs, which is substantially smaller thanthe bid-ask spread. For international ETFs, the findings are not sodramatic. Premiums and discounts are much larger and more persistent,frequently lasting several days. The spreads are also much wider and arecomparable to the standard deviation of the premiums. This finding isinsensitive to the timing of overlap with the foreign market, the use offutures data, or different levels of time scale. In fact there are onlya small number of trades and quote changes in a typical day for most ofthese funds. An explanation for this difference may rest with the highercost of creation and redemption for the international products.Nevertheless, when compared with closed end funds where there are noopportunities for creation or redemption, the ETFs have smaller and lesspersistent premiums and discounts. The implication is that the pricingof ETFs is highly efficient for the domestic products and somewhat lessprecise for the international funds since they face more complexfinancial transactions and risks. http://hdl.handle.net/2451/26910 Title: Pricing Credit Derivatives with Rating Transitions<br/><br/>Acharya, Viral V.; Das, Sanjiv Ranjan; Sundaram, Rangarajan K.<br/><br/>Abstract: We develop a model for pricing risky debt and valuing credit derivativesthat is easily calibrated to existing variables. Our approach is basedon expanding the Das and Sundaram (2000) extension of theHeath-Jarrow-Morton (1990) term-structure model to allow for multipleratings classes of debt. The framework has two salient features: (i) itemploys a ratings transition matrix as the driver or the defaultprocess, and (ii) the entire set of rating categories is calibratedjointly, allowing arbitrage-free restrictions across rating classes, asa bond migrates amongst them. We provide an illustration of the approachby applying it to price credit-sensitive notes that have coupon paymentsthat are linked to the rating of the underlying credit. http://hdl.handle.net/2451/26812 Title: PREDATORY TRADING<br/><br/>Brunnermeier, Markus K.; Pedersen, Lasse Heje<br/><br/>Abstract: This paper studies predatory trading: trading that induces and/orexploits other investors&rsquo; need to reduce their positions. We showthat if one trader needs to sell, others also sell and subsequently buyback the asset. This leads to price overshooting and a reducedliquidation value for the distressed trader. Hence, the market isilliquid when liquidity is most needed. Further, a trader profits fromtriggering another trader&rsquo;s crisis, and the crisis can spill overacross traders and across markets. http://hdl.handle.net/2451/26815 Title: Political News and Stock Prices: The Case of Saddam Hussein Contracts<br/><br/>Amihud, Yakov; Wohl, Avi<br/><br/>Abstract: This paper studies the association between the market&rsquo;sexpectations of Saddam Hussein&rsquo;s fall from power, reflected in&quot;Saddam contract&quot; prices, and stock prices, oil prices andexchange rates. During the war, a rise in the probability ofSaddam&rsquo;s fall, which also indicated a speedy end to the war, waspositively and significantly associated with stock prices, strengthenedthe dollar against the Euro, and lowered oil prices. Before the war, arise in the probability of Saddam&rsquo;s fall, which may have alsoindicated the probability of a costly war breaking out, lowered stockprices, which adjustment gradually to this information. http://hdl.handle.net/2451/26794 Title: Performance-Sensitive Debt<br/><br/>Manso, Gustavo; Strulovici, Bruno; Tchistyi, Alexei<br/><br/>Abstract: This paper studies performance-sensitive debt (PSD), the class of debtobligations whose interest payments depend on some measure of theborrower&rsquo;s performance. For example, step-up bonds compensatecredit rating downgrades with higher interest rates, and reward creditrating upgrades with lower interest rates. In an endogenous defaultsetting, we develop an algorithm to value PSD obligations allowing forgeneral payment profiles, and obtain closed-form pricing formulas inimportant special cases, including step-up bonds. Moreover, we provide acriterion to compare different PSD obligations in terms of theirefficiency. In particular, we find that step-up bonds lead to earlierdefault and lower the market value of the issuing firm&rsquo;s equity,compared to fixed-coupon bonds of the same market value. Lastly, weanalyze the implications of our results for the policy of credit-rating agencies. http://hdl.handle.net/2451/26877 Title: On Rescissions in Executive Stock Options<br/><br/>Brenner, Menachem; Sundaram, Rangarajan K; Yermack, David http://hdl.handle.net/2451/26891 Title: Modeling Sovereign Yield Spreads: A Case Study of Russian Debt<br/><br/>Duffie, Darrell; Pedersen, Lasse Heje; Singleton, Kenneth J.<br/><br/>Abstract: We construct a model for pricing sovereign debt that accounts for therisks of both default and restructuring, and allows for compensation forilliquidity. Using a new and relatively efficient method, we estimatethe model using Russian dollar-denominated bonds. We consider thedeterminants of the Russian yield spread, the yield differential acrossdifferent Russian bonds, and the implications for market integration,relative liquidity, relative expected recovery rates, and impliedexpectations of different default scenarios. http://hdl.handle.net/2451/26884 Title: Margin Rules, Informed Trading in Derivatives, and Price Dynamics<br/><br/>JOHN, Kose; KOTICHA, Apoorva; NARAYANAN, Ranga; SUBRAHMANYAM, Marti<br/><br/>Abstract: We analyze the impact of option trading and margin rules on the behaviorof informed traders and on the microstructure of stock and optionmarkets. In the absence of binding margin requirements, the introductionof an options market causes informed traders to exhibit a relativetrading bias towards the stock because of its greater informationsensitivity. In turn, this widens the stock's bid-ask spread. But wheninformed traders are subject to margin requirements, their bias towardsthe stock is enhanced or mitigated depending on the leverage provided bythe option relative to the stock, leading to wider or narrower stockbid-ask spreads. The introduction of option trading, with or withoutmargin requirements, unambiguously improves the informational efficiencyof stock prices. Margin rules improve market efficiency when stock andoption margins are sufficiently large or small but not when they are ofmoderate size. http://hdl.handle.net/2451/26897 Title: Major League Baseball Player Contracts: An Investigation of theEmpirical Properties of Real Options<br/><br/>Clayton, Matthew; Yermack, David<br/><br/>Abstract: We study contracts negotiated between professional baseball players andteams to investigate the use of real options in a commercial setting.Baseball contracts feature options in diverse forms, and we find thatthese options have significant effects on player compensation. Aspredicted by theory, players receive higher guaranteed compensation whenthey allow teams to take options on their future services, and lowersalaries when they bargain for options to extend their own contracts.The apparent value of options decreases as a function of the&quot;spread&quot; between option exercise price and annual salary andincreases as a function of the time until exercise. Implied volatilityof the options lies within the range found for other assets. http://hdl.handle.net/2451/26811 Title: Liquidity in the Futures Pits: Inferring Market Dynamics from Incomplete Data<br/><br/>Hasbrouck, Joel<br/><br/>Abstract: Motivated by economic models of sequential trade, empirical analyses ofmarket dynamics frequently estimate liquidity as the coefficient ofsigned order flow in a price-change regression. This paper implementssuch an analysis for futures transaction data from pit trading. To dealwith the absence of timely bid and ask quotes (which are used to signtrades in most equity-market studies), this paper proposes newtechniques based on Markov chain Monte Carlo estimation. The model isestimated for four representative Chicago Mercantile Exchange contracts.The highest liquidity (lowest order flow coefficient) is found for theS&amp;P index. Liquidity for the Euro and UK &pound; contracts issomewhat lower. The pork belly contract exhibits the least liquidity. http://hdl.handle.net/2451/26831 Title: Limited Arbitrage and Short Sales Restrictions: Evidence from theOptions Markets<br/><br/>Ofek, Eli; Richardson, Matthew; Whitelaw, Robert F.<br/><br/>Abstract: In this paper, we investigate empirically the well-known put-call parityno-arbitrage relation in the presence of short sale restrictions. We usea new and comprehensive sample of options on individual stocks incombination with a measure of the cost and difficulty of short selling,specifically the spread between the rate a short-seller earns on theproceeds from the sale relative to the normal rate (the rebate ratespread). We find statistically and economically significant violationsof put-call parity that are strongly related to the rebate rate spread.Stocks with negative rebate rate spreads exhibit prices in the stockmarket that are up to 7.5% greater than those implied in the optionsmarket (for the extreme 1% tail). Even after accounting for transactioncosts in the options markets, these violations persist and theirmagnitude appears to be related to the general level of valuations inthe stock market. Moreover, the extent of violations of put-call parityand the rebate rate spread for individual stocks are significantpredictors of future stock returns. For example, cumulative abnormalreturns, net of borrowing costs, over a 2&frac12;-year sample period canexceed 70%. It is difficult to reconcile these results with rationalmodels of investor behavior, and, in fact, they are consistent with thepresence of over-optimistic irrational investors in the markets for someindividual securities. http://hdl.handle.net/2451/26820 Title: Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE<br/><br/>Boehmer, Ekkehart; Saar, Gideon; Yu, Lei<br/><br/>Abstract: This paper investigates an important feature of market design: pre-tradetransparency, defined as the availability of information about pendingtrading interest in the market. We look at how the NYSE&rsquo;sintroduction of OpenBook, which enables traders off the exchange floorto observe depth in the limit order book in real time, affects thetrading strategies of investors and specialists, informationalefficiency, liquidity, and returns. We find that traders attempt tomanage the exposure of their limit orders: the cancellation rateincreases, time-to-cancellation shortens, and smaller orders aresubmitted. The new information OpenBook provides seems to cause tradersto prefer managing the trading process themselves, rather thandelegating this task to floor brokers. We also show thatspecialists&rsquo; participation rate in trading decreases and the depththey add to the quote goes down, consistent with a loss of theirinformational advantage or with being &quot;crowded out&quot; by activelimit order strategies. We detect an improvement in the informationalefficiency of prices after the introduction of OpenBook. Greaterpre-trade transparency leads to some improvement in displayed liquidityin the book and a reduction in the execution costs of trades. We findthat cumulative abnormal returns are positive following the introductionof OpenBook, consistent with the view that improvement in liquidityaffects stock returns. http://hdl.handle.net/2451/26888 Title: Large Scale Conditional Covariance Matrix Modeling, Estimation and Testing<br/><br/>Ding, Zhuanxin; Engle, Robert F.<br/><br/>Abstract: A new representation of the diagonal Vech model is given using theHadamard product. Sufficient conditions on parameter matrices areprovided to ensure the positive definiteness of covariance matrices fromthe new representation. Based on this, some new and simple models arediscussed. A set of diagnostic tests for multivariate ARCH models isproposed. The tests are able to detect various model misspecificationsby examing the orthogonality of the squared normalized residuals. Asmall Monte-Carlo study is carried out to check the small sampleperformance of the test. An empirical example is also given as guidancefor model estimation and selection in the multivariate framework. Forthe specific data set considered, it is found that the simple one andtwo parameter models and the constant conditional correlation modelperform fairly well. http://hdl.handle.net/2451/26799 Title: Intermediation and Value Creation in an Incomplete Market: Implicationsfor Securitization<br/><br/>Gaur, Vishal; Seshadri, Sridhar; Subrahmanyam, Marti G.<br/><br/>Abstract: This paper studies the impact of financial innovations on realinvestment decisions. We model an incomplete market economy comprised offirms, investors and an intermediary. The firms face unique investmentopportunities that are not spanned by the traded securities in thefinancial market, and thus, cannot be priced uniquely using theno-arbitrage principle. The specific innovation we consider issecuritization; the intermediary buys claims from the firms that arefully backed by cash flows from the new projects, pools these claimstogether, and then issues tranches of secondary securities to theinvestors. We first derive necessary and sufficient conditions underwhich pooling provides value enhancement and the prices paid to thefirms are acceptable to them compared to the no-investment option or theoption of forming alternative pools. We find that there is a unique poolthat is sustainable, and may or may not consist of all projects in theintermediary&rsquo;s consideration set. We then determine the optimaldesign of tranches, fully backed by the asset pool, to be sold todifferent investor classes. We determine the general structure of thetranches. The new securities created by the intermediary could have upto three components, one that is a marketable claim, one that representsthe arbitrage opportunities available in the market due to specialability to design and sell securities to a subset of investors, and athird component that is the rest of the asset pool which is sold at aprice which does not exceed arbitrage based bounds to investors. Thepresence of these three components in the tranching solution has directbearing upon the size of the asset pool, and therefore value creationdue to financing additional projects. http://hdl.handle.net/2451/26805 Title: Interest Rate Option Markets: The Role of Liquidity in Volatility Smiles<br/><br/>Deuskar, Prachi; GUPTA, ANURAG; SUBRAHMANYAM, MARTI G.<br/><br/>Abstract: We investigate the interaction of volatility smiles and liquidity in theeuro (&euro;) interest rate option markets, using daily bid and askprices of interest rate caps/floors. We find that liquidity variableshave significant explanatory power for both curvature and asymmetry ofthe implied volatility smiles. This effect is generally stronger on theask side, indicating that ask-prices are more relevant for thesemarkets. In addition, the shape of the implied volatility smile has someinformation about future levels and volatility of the term structure.Our results have important implications for the modeling and riskmanagement of fixed income derivatives. http://hdl.handle.net/2451/26806 Title: Improved Estimates of Correlation Coefficients And Their Impact on theOptimum Portfolios<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Spitzer, Jonathan<br/><br/>Abstract: To implement mean variance analysis one needs a technique forforecasting correlation coefficients. In this article we investigate theability of several techniques to forecast correlation coefficientsbetween securities. We find that separately forecasting the averagelevel of pair-wise correlations and individual pair-wise differencesfrom the average improves forecasting accuracy. Furthermore, forminghomogenous groups of firms on the basis of industry membership or firmattributes (eg. Size) improves forecast accuracy. Accuracy is evaluatedin two ways: First, in terms of the error in estimating futurecorrelation coefficients. Second, in the characteristics of portfoliosformed on the basis of each forecasting technique. The ranking offorecasting techniques is robust across both methods of evaluation andthe better techniques outperform prior suggestions in the literature offinancial economics. http://hdl.handle.net/2451/26883 Title: HEDGING VOLATILITY RISK<br/><br/>Brenner, Menachem; Ou, Ernest Y.; Zhang, Jin E.<br/><br/>Abstract: Volatility risk has played a major role in several financial debacles(for example, Barings Bank, Long Term Capital Management). This riskcould have been managed using options on volatility which were proposedin the past but were never offered for trading mainly due to the lack ofa tradable underlying asset. The objective of this paper is to introducea new volatility instrument, an option on a straddle, which can be usedto hedge volatility risk. The design and valuation of such an instrumentare the basic ingredients of a successful financial product. Unlike theproposed volatility index option, the underlying of this proposedcontract is a traded atthe-money-forward straddle, which should be moreappealing to potential participants. In order to value these options, wecombine the approaches of compound options and stochastic volatility. Weuse the lognormal process for the underlying asset, theOrenstein-Uhlenbeck process for volatility, and assume that the twoBrownian motions are independent. Our numerical results show that thestraddle option price is very sensitive to the changes in volatilitywhich means that the proposed contract is indeed a very powerfulinstrument to hedge volatility risk. http://hdl.handle.net/2451/26807 Title: Fees on Fees in Funds of Funds<br/><br/>Brown, Stephen J.; Goetzmann, William N.; Liang, Bing<br/><br/>Abstract: Funds of funds are an increasingly popular avenue for hedge fundinvestment. Despite the increasing interest in hedge funds as analternative asset class, the high degree of fund specific risk and thelack of transparency may give fiduciaries pause. In addition, many ofthe most attractive hedge funds are closed to new investment. Funds offunds resolve these issues by providing investors with diversificationacross manager styles and professional oversight of fund operations thatcan provide the necessary degree of due diligence. In addition, manysuch funds hold shares in hedge funds otherwise closed to new investmentallowing smaller investors access to the most sought-after managers.However, the diversification, oversight and access comes at the cost ofa multiplication of the fees paid by the investor. One would expect thatthe information advantage of funds of funds would more than compensateinvestors for these fees. Unfortunately, individual hedge funds dominatefund of funds on an after-fee return or Sharpe ratio basis. In thispaper we argue that the disappointing after-fee performance of some fundof funds might be explained by the nature of this fee arrangement, andthat fund of funds providers may actually benefit from considering otherpossible fee arrangements. These alternative arrangements will improvereported performance and may make funds of funds more attractive to agrowing institutional clientele. http://hdl.handle.net/2451/26816 Title: Estimation Error in the Assessment of Financial Risk Exposure<br/><br/>Figlewski, Stephen<br/><br/>Abstract: Value at Risk and similar measures of financial risk exposure requirepredicting the tail of an asset returns distribution. Assuming aspecific form, such as the normal, for the distribution, the standarddeviation (and possibly other parameters) are estimated from recenthistorical data and the tail cutoff value is computed. But this standardprocedure ignores estimation error, which we find to be substantial evenunder the best of conditions. In practice, a &quot;tail event&quot; mayrepresent a truly rare occurrence, or it may simply be a not-so-rareoccurrence at a time when the predicted volatility underestimates thetrue volatility, due to sampling error. This problem gets worse thefurther in the tail one is trying to predict. Using a simulation of10,000 years of daily returns, we first examine estimation risk whenvolatility is an unknown constant parameter. We then consider the morerealistic, but more problematical, case of volatility that driftsstochastically over time. This substantially increases estimation error,although strong mean reversion in the variance tends to dampen theeffect. Non-normal fat-tailed return shocks makes overall riskassessment much worse, especially in the extreme tails, but estimationerror per se does not add much beyond the effect of tail fatness. Usingan exponentially weighted moving average to downweight older data hurtsaccuracy if volatility is constant or only slowly changing. But withmore volatile variance, an optimal decay rate emerges, with betterperformance for the most extreme tails being achieved using a relativelygreater rate of downweighting. We first simulate non-overlappingindependent samples, but in practical risk management, risk exposure isestimated day by day on a rolling basis. This produces strongautocorrelation in the estimation errors, and bunching of apparentlyextreme events. We find that with stochastic volatility, estimationerror can increase the probabilities of multi-day events, like three 1%tail events in a row, by several orders of magnitude. Finally, we reportempirical results using 40 years of daily S&amp;P 500 returns whichconfirm that the issues we have examined in simulations are also presentin the real world. http://hdl.handle.net/2451/26801 Title: Employee Stock Options (ESOPs) and Restricted Stock: Valuation Effectsand Consequences<br/><br/>Damodaran, Aswath<br/><br/>Abstract: In the last decade, firms have increasingly turned to offering employeesoptions and restricted stock (often with restrictions on trading) aspart of compensation packages. Some of this trend can be attributed tothe entry of young, cash poor technology firms into the market, many ofwhich have to use equity because they have no choice. However, manylarger market cap firms that can afford to pay cash compensation haveused stock based compensation as a way of aligning managerial interestswith stockholder interests. In this paper, we begin by looking atmotives, good and bad, for using equity based compensation, and trendsover the last few years. We then turn to the accounting rules, old andnew, that govern how equity compensation is recorded and reported.Finally, we consider how best to incorporate employee options andrestricted stock &ndash; both past and prospective &ndash; intodiscounted cash flow and relative valuation models. http://hdl.handle.net/2451/26916 Title: Empirical pricing kernels<br/><br/>Rosenberg, Joshua V.; Engle, Robert F.<br/><br/>Abstract: This paper investigates the empirical characteristics of investor riskaversion over equity return states by estimating a daily semi-parametricpricing kernel. The two key features of this estimator are: (1) thefunctional form of the pricing kernel is estimated semi-parametrically,instead of being prespecified and (2) the pricing kernel is re-estimatedon a daily basis, allowing measurement of time-variation in riskaversionover equity return states. Important empirical findings of the paperare as follows. Constant relative risk aversion over S&amp;P500 returnstates is rejected in favor of a model in which relative risk aversionis stochastic. Empirical relative risk aversion over equity returnstates is found to be positively autocorrelated and positivelycorrelated with the spread between implied and objective volatilities.In addition, the constant relative risk aversion (power utility) pricingkernel is found to underestimate the value of payoffs in large negativereturn states. An option hedging methodology is developed as a test ofthe predictive information in the empirical pricing kernel and itsassociated state probability model. The results of hedging performancetests for out-of-the-money S&amp;P500 index put options indicate thattime-varying risk aversion over equity return states is an importantfactor affecting option prices. http://hdl.handle.net/2451/26879 Title: DYNAMIC CONDITIONAL CORRELATION : A SIMPLE CLASS OF MULTIVARIATE GARCH MODELS<br/><br/>Engle, Robert<br/><br/>Abstract: Time varying correlations are often estimated with Multivariate Garchmodels that are linear in squares and cross products of the data. A newclass of multivariate models called dynamic conditional correlation(DCC) models is proposed. These have the flexibility of univariate GARCHmodels coupled with parsimonious parametric models for the correlations.They are not linear but can often be estimated very simply withunivariate or two step methods based on the likelihood function. It isshown that they perform well in a variety of situations and providesensible empirical results. http://hdl.handle.net/2451/26825 Title: Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors?<br/><br/>Sangvinatsos, Antonios; Wachter, Jessica<br/><br/>Abstract: We consider the consumption and portfolio choice problem of a long-runinvestor when the term structure is affine and when the investor hasaccess to nominal bonds and a stock portfolio. In the presence ofunhedgeable inflation risk, there exist multiple pricing kernels thatproduce the same bond prices, but a unique pricing kernel equal to themarginal utility of the investor. We apply our method to a three-factorGaussian model with a time-varying price of risk that captures thefailure of the expectations hypothesis seen in the data. We extend thismodel to account for time-varying expected inflation, and estimate themodel with both inflation and term structure data. The estimates implythat the bond portfolio for the long-run investor looks very differentfrom the portfolio of a mean-variance optimizer. In particular, thedesire to hedge changes in term premia generates large hedging demandsfor long-term bonds. http://hdl.handle.net/2451/26822 Title: Does Mutual Fund Performance Vary over the Business Cycle?<br/><br/>Boudry, Walter; Lynch, Anthony W.; Wachter, Jessica<br/><br/>Abstract: Conditional factor models allow both risk loadings and performance overa period to be a function of information available at the start of theperiod. Much of the literature to date has allowed risk loadings to betime-varying while imposing the assumption that conditional performanceis constant. We develop a new methodology that allows conditionalperformance to be a function of information available at the start ofthe period. This methodology uses the Euler equation restriction thatcomes out of the factor model rather than the beta pricing formulaitself. The Euler equation restrictions that we develop can be estimatedusing GMM. It is also possible to allow the factor returns to havelonger data series than the mutual fund series as in Stambaugh (1997).We use our method to assess the conditional performance of funds in theElton, Gruber and Blake (1996) mutual fund data set. Using dividendyield to track the business cycle, we find that conditional mutual fundperformance moves with the business cycle, with all fund types exceptgrowth performing better in downturns than in peaks. The converse holdsfor growth funds, which do better in peaks than in downturns. http://hdl.handle.net/2451/26821 Title: Do Asset Prices Reflect Fundamentals? Freshly Squeezed Evidence from theOJ Market<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Shen, YuQing; Whitelaw, Robert F.<br/><br/>Abstract: The behavioral finance literature cites the frozen concentrated orangejuice (FCOJ) futures market as a prominent example of the failure ofprices to reflect fundamentals. In contrast, we show that when theoryclearly identifies the fundamental, e.g.,temperatures close to or belowfreezing, there is a close link between FCOJ prices and thatfundamental. Using a simple, theoreticallymotivated, nonlinear, statedependent model, we can explain approximately 50% of the returnvariation on days with freezing temperatures. Moreover, while theseobservations represent less than 4.5% of the winter sample, they accountfor two-thirds of the entire winter return variability. http://hdl.handle.net/2451/26791 Title: Demand-Based Option Pricing<br/><br/>G&acirc;rleanu, Nicolae; Pedersen, Lasse Heje; Poteshman, Allen M.<br/><br/>Abstract: We model demand-pressure effects on option prices. The model shows thatdemand pressure in one option contract increases its price by an amountpro- portional to the variance of the unhedgeable part of the option.Similarly, the demand pressure increases the price of any other optionby an amount propor- tional to the covariance of their unhedgeableparts. Empirically, we identify aggregate positions of dealers and endusers using a unique dataset, and show that demand-pressure effectscontribute to well-known option-pricing puzzles. In- deed, time-seriestests show that demand helps explain the overall expensiveness and skewpatterns of both index options and single-stock options http://hdl.handle.net/2451/26814 Title: Cyclicality in Catastrophic and Operational Risk Measurements<br/><br/>Allen, Linda<br/><br/>Abstract: Using equity returns for financial institutions we estimate bothcatastrophic and operational risk measures over the period 1973-2001. Wefind evidence of cyclical components in both the catastrophic andoperational risk measures obtained from the Generalized ParetoDistribution and the Skewed Generalized Error Distribution. Our new,comprehensive approach to measuring operational risk shows thatapproximately two thirds of financial institutions&rsquo; returnsrepresents compensation for operational risk. http://hdl.handle.net/2451/26889 Title: Credit Risk and the Yen Interest Rate Swap Market<br/><br/>Eom, Young Ho; Subrahmanyam, Marti G.; Uno, Jun<br/><br/>Abstract: In this paper, we investigate the pricing of Japanese yen interest rateswaps during the period 1990-96. We obtain measures of the spreads ofthe swap rates over comparable Japanese Government Bonds (JGBs) fordifferent maturities and analyze the relationship between the swapspreads and credit risk variables. Our empirical results in the yen swapmarket indicate that: 1) the commonly-used assumption of lognormaldefault-free interest rates and swap spreads is strongly rejected by thedata, 2) the term structure of swap spreads displays a humped-shape, and3) the shocks in the yen swap spread are negatively correlated with theshocks in the comparable default-free spot rates, especially for longermaturities. Our analysis also indicates that yen swap spreads behavedvery differently from the credit spreads on Japanese corporate bonds inthe early nineties. In contrast to Japanese corporate bonds, we findthat the yen swap spread is also significantly related to proxies forthe long-term credit risk factor. Furthermore, the swap spread isnegatively related to the level and slope of the term structure andpositively related to the curvature, indicating that the credit&quot;optionality&quot; is priced in the swap rate. Thus, overall, theyen swap market was sensitive to credit risk during the period of our study. http://hdl.handle.net/2451/26914 Title: Comovement<br/><br/>Barberis, Nicholas; Shleifer, Andrei; Wurgler, Jeffrey<br/><br/>Abstract: A number of studies have identified patterns of positive correlation ofreturns, or comovement, among different traded securities. Wedistinguish three views of such co- movement. The traditional&quot;fundamentals&quot; view explains the comovement of securitiesthrough positive correlations in the rational determinants of theirvalues, such as cash ows or discount rates. &quot;Category-based&quot;comovement occurs when investors classify different securities into thesame asset class and shift resources in and out of this class incorrelated ways. A related phenomenon of &quot;habitat-based&quot;comovement arises when a group of investors restricts its trading to agiven set of securities, and moves in and out of that set in tandem. Wepresent models of each of the three types of comovement, and then assessthem empirically using data on stock inclusions into and deletions fromthe S&amp;P 500 index. Index changes are noteworthy because they changea stock's category and investor clientele (habitat), but do not changeits fundamentals. We find that when a stock is added to the index, itsbeta and R-squared with respect to the index increase, while its betawith respect to stocks outside the index falls. The converse happenswhen a stock is deleted. These results are broadly supportive of thecategory and habitat views of comovement, but not of the fundamentalsview. More generally, we argue that these non-traditional views may helpexplain other instances of comovement in the data. http://hdl.handle.net/2451/26808 Title: Comovement<br/><br/>Barberis, Nicholas; Shleifer, Andrei; Wurgler, Jeffrey<br/><br/>Abstract: We consider two broad views of return comovement: the traditional view,derived from frictionless economies with rational investors, whichattributes it to comovement in news about fundamental value, and analternative view, in which market frictions or noise-trader sentimentdelink it from comovement in fundamentals. Building on Vijh (1994), weuse data on inclusions into the S&amp;P 500 to distinguish these views.After inclusion, a stock's beta with the S&amp;P goes up. In bivariateregressions which control for the return of non-S&amp;P stocks, theincrease in S&amp;P beta is even larger. These results are generallystronger in more recent data. Our findings cannot easily be explained bythe fundamentals-based view and provide new evidence in support of thealternative friction- or sentiment-based view. http://hdl.handle.net/2451/26804 Title: Benefits of Broad-Based Option Pay<br/><br/>Inderst, Roman; M&uuml;ller, Holger M.<br/><br/>Abstract: Future wage payments drive a wedge between total firm output and theoutput share received by the firm&rsquo;s owners, thus potentiallydistorting strategic decisions by the firm&rsquo;s owners such as, e.g.,whether to continue the firm, sell it, or shut it down. Using an optimalcontracting approach, we show that the unique optimal firm-wide employeecompensation scheme from this perspective is a broad-based option plan.Broad-based option pay minimizes the firm&rsquo;s expected future wagepayments in states of nature where the firm is only marginallyprofitable, thus making continuation as attractive as possible inprecisely those states of nature where, e.g., a high fixed wage wouldlead the firm&rsquo;s owners to inefficiently exit. http://hdl.handle.net/2451/26792 Title: Asset Pricing with Liquidity Risk<br/><br/>Acharya, Viral V.; Pedersen, Lasse Heje<br/><br/>Abstract: This paper solves explicitly a simple equilibrium model with liquidityrisk. In our liquidityadjusted capital asset pricing model, asecurity&rsquo;s required return depends on its expected liquidity aswell as on the covariances of its own return and liquidity with themarket return and liquidity. In addition, a persistent negative shock toa security&rsquo;s liquidity results in low contemporaneous returns andhigh predicted future returns. The model provides a unified frameworkfor understanding the various channels through which liquidity risk mayaffect asset prices. Our empirical results shed light on the total andrelative economic significance of these channels and provide evidence offlight to liquidity. r 2005 Elsevier B.V. All rights reserved. http://hdl.handle.net/2451/26875 Title: Assessing the Incremental Value of Option Pricing Theory Relative to an&lsquo;Informationally Passive&rsquo; Benchmark<br/><br/>Figlewski, Stephen<br/><br/>Abstract: In modern finance, the value of an active investment strategy ismeasured by comparing its performance against the benchmark of passivelyholding the market portfolio and the riskless asset. We wish to evaluatethe marginal contribution of a theoretical derivatives pricing model inthe same way, by comparing its performance against an&quot;informationally passive&quot; alternative model. All rationallypriced options must satisfy a number of conditions to rule outprofitable static arbitrage. The Black-Scholes model, and others likeit, are obtained by assuming an equilibrium in which there are noprofitable dynamic arbitrage opportunities either. The passive model weconsider incorporates only the fundamental properties of option pricesthat must hold to avoid static arbitrage, but has no theoretical contentbeyond that. We review different measures of model performance and applythem to several versions of the Black-Scholes model and our passivemodel. As with active portfolio management, it turns out to be not thateasy for an &quot;active&quot; model to do a lot better than a welldesigned passive alternative. For example, &quot;classical&quot;Black-Scholes model turns out to be less accurate than the passive benchmark. http://hdl.handle.net/2451/26810 Title: An Explanation for the Joint Evolution of Firm and Aggregate Volatility<br/><br/>Philippon, Thomas<br/><br/>Abstract: The US economy has become more stable. At the same time, US firms havebecome more volatile. I present the evidence and I propose a commonexplanation, based on the idea that goods markets have become morecompetitive. Competition between firms magnifies the effects ofidiosyncratic productivity shocks: This can explain the rise in firmvolatility. On the other hand, for given nominal adjustment costs,competitive pressures will induce firms to increase the frequency oftheir price adjustments. As a result, the economy will be more resilientto aggregate demand shocks. My calibration suggests that competitivepressures may have reduced the impact of demand shocks by 40%. http://hdl.handle.net/2451/26913 Title: An Examination of the Static and Dynamic Performance of Interest RateOption Pricing Models In the Dollar Cap-Floor Markets<br/><br/>Gupta, Anurag; Subrahmanyam, Marti G.<br/><br/>Abstract: This paper examines the static and dynamic accuracy of interest rateoption pricing models in the U.S. dollar interest rate cap and floormarkets. We evaluate alternative one-factor and two-factor termstructure models of the spot and the forward interest rates on the basisof their out-of-sample predictive ability in terms of pricing andhedging performance. The one-factor models analyzed consist of twospot-rate specifications (Hull and White (1990) and Black-Karasinski(1991), five forward rate specifications (within the general Heath,Jarrow and Morton (1990b) class), and one LIBOR market model (Brace,Gatarek and Musiela (1997) [BGM]). For two-factor models, twoalternative forward rate specifications are implemented within the HJMframework. We conduct tests on daily data from March-December 1998,consisting of actual cap and floor prices across both strike rates andmaturities. Results show that fitting the skew of the underlyinginterest rate distribution provides accurate pricing results within aone-factor framework. However, for hedging performance, introducing asecond stochastic factor is more important than fitting the skew of theunderlying distribution. Overall, the one-factor lognormal model forshort term interest rates outperforms other competing models in pricingtests, while two-factor models perform significantly better thanone-factor models in hedging tests. Modeling the second factor allows abetter representation of the dynamic evolution of the term structure byincorporating expected twists in the yield curve. Thus, the interestrate dynamics embedded in two-factor models appears to be closer to theone driving the actual economic environment, leading to more accuratehedges. This constitutes evidence against claims in the literature thatcorrectly specified and calibrated one-factor models could replacemulti-factor models for consistent pricing and hedging of interest ratecontingent claims. http://hdl.handle.net/2451/26819 Title: A Simulation-Based Pricing Method for Convertible Bonds<br/><br/>Kind, Axel; Wilde, Christian<br/><br/>Abstract: We propose a pricing model for convertible bonds based on Monte Carlosimulation that is more flexible than previous lattice-based methodsbecause it allows to better capture the dynamics of the underlying statevariables. Furthermore, the model is able to deal with embeddedAmerican-style put and call features with path-dependent triggerconditions. The simulation method uses parametric representations of theearly exercise decisions and consists of two stages. In the first stage,the parameters representing the exercise strategies are optimized on aset of simulated stock prices. Subsequently, the optimized parametersare applied to a new simulation set to determine the model price. In anempirical analysis, the model is found to provide a better fit comparedto previous studies. http://hdl.handle.net/2451/26904 Title: A Parimutuel Market Microstructure for Contingent Claims Trading<br/><br/>Lange, Jeffrey; Economides, Nicholas<br/><br/>Abstract: A parimutuel market microstructure for contingent claims trading isproposed and analyzed. A parimutuel microstructure is a call auctionwhere relative equilibrium prices of contingent claims are endogenouslydetermined using a specific mechanism. We propose a marketmicrostructure incorporating parimutuel principles which provides fornotional derivatives transactions, limit orders, and bundling ofcontingent claims across states. This microstructure will be used byLongitude Inc.'s clients to transact derivatives on economic statistics,weather, insurance losses and other types of risks. JPMorgan Chase andDeutsche Bank are some of the financial institutions that will beholding parimutuel auctions in early 2002. http://hdl.handle.net/2451/26809 Title: A Multiple Indicators Model For Volatility Using Intra-Daily Data<br/><br/>Engle, Robert F.; Gallo, Giampiero M.<br/><br/>Abstract: Many ways exist to measure and model financial asset volatility. Inprinciple, as the frequency of the data increases, the quality offorecasts should improve. Yet, there is no consensus about a&ldquo;true&rdquo; or &quot;best&quot; measure of volatility. In thispaper we propose to jointly consider absolute daily returns, dailyhigh-low range and daily realized volatility to develop a forecastingmodel based on their conditional dynamics. As all are non-negativeseries, we develop a multiplicative error model that is consistent andasymptotically normal under a wide range of specifications for the errordensity function. The estimation results show significant interactionsbetween the indicators. We also show that one-month-ahead forecastsmatch well (both in and out of sample) the market-based volatilitymeasure provided by an average of implied volatilities of index optionsas measured by VIX.