We develop a new approach to determine investors' risk compensations for all distributional moments of a security. Using the concept of entropy, a summary of all moments of a risky security, we derive the exact link between expected returns and their compensation for entropy risk. Entropy risk premium (ERP), the difference of entropy under the physical and risk-neutral measures, indicates the cost to financially hedge against changes in all assets' risks. We find that ERP carries significant predictive power for the cross-section of commodity returns even after removing its variance and skewness risk components.
Work in Progress
Energy risks carry systematic effects in the cross-section of stocks. Using a recursive framework, we endogenously derive expected returns and show that investors are willing to pay a premium to access relevant information about future events sooner than later. Increasing energy risks decrease firms' investments, triggering an amplification mechanism that impact expected returns. We empirically confirm this channel, stocks with lower energy risk exposure exhibit higher future returns, indicating that investors demand extra compensation to hold these assets. With commodity financialization, the energy-equity markets link increases, and so does the accuracy of energy risk exposure to predict future returns.
The entropy risk premium of the equity risk premium
We provide novel evidence that equity investors react to currency shocks with a delay. Using the cross-section of currency returns and the relative presence of U.S. multinational firms in foreign economies, we compute a foreign operations related exchange shock (FOREXS) measure. We find FOREXS to predict firms' future cash flows and stock returns, driving much of the previously documented underreaction to foreign information. A strategy that buys stocks with high FOREXS and shorts stocks with low FOREXS yields a 6.74% annualized abnormal return. We show that the predictive power comes from incomplete hedging by the firms and limited attention by the investors. Our results thus highlight the important role of investor attention in facilitating information transmission across asset classes.
We specify and estimate a no-arbitrage model for sovereign CDS contracts in which countries’ default intensities depend on economic and financial indicators. To facilitate identification and to distinguish the importance of local and global covariates, we estimate a model with three global and four local covariates using CDS spreads for five maturities and twenty-five countries. The model provides a good fit. The impact of the economic and financial variables on spreads is consistent with economic intuition, and substantially varies across countries and over time. Estimated risk premiums are highly variable and peak during the 2008 financial crisis for most countries.
Competition and credit risk
We study the implications of financial frictions for the distribution and dynamics of lending spreads. These spreads are determined endogenously by the interaction between lenders and borrowers. Small shocks to the distribution of borrowers' prospects amplify through the economy, generating feedback effects on spreads. The model captures the joint dynamics of economic and financial variables observed in the data. Increased uncertainty about borrowers' prospects increases default rates and lending spreads, and decreases total lending. The model matches the historical averages for economic indicators as well as the level and persistence of lending spreads, but it generates excess volatility of spreads.
The Low Energy Investor: Energy Risks and the Cross Section of Stock Returns
Willingness to pay and default uncertainty
Digesting FOREXS (with Joon Woo Bae and Zhi Da)
Financial Frictions and Loan Spreads, Revise and Resubmit, Journal of Financial and Quantitative Analysis