The Low Energy Investor: Energy Risks, Investments and Stock Returns
Published and Accepted Papers
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 relationship between expected returns and their compensation for entropy risk. Entropy risk premium (ERP), entropy under the physical minus the risk-neutral measures, indicates the hedging cost against changes in risks associated with all moments of the return's distribution. Applying our model to the commodity markets we find that ERP carries economically significant information for the cross-section of returns that is different from individual or combined moments.
Weather Variance Risk Premia (with Joon Woo Bae, Yoontae Jeon and Stephen Szaura)
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.
Work in Progress
We develop a dynamic production-based model with real options to examine the implications of changes in output, investment and financial policies on firms' future stock return distributions. We introduce novel, competing channels showing that cash-flow hedging and capital investment by firms endogenously impact not only future variance, but also future skewness and kurtosis. Empirically, using option prices and hand-collected data on firms' risk management policies, we find that hedging exhibits a pull-to-normality effect on firms' returns, reducing future variance, excess negative skewness and excess kurtosis, while this effect is offset with increasing levels of investments.
Willingness To Pay and Default Risk
We analyze the information content of a variance risk premia extracted from the weather derivatives contracts written on the local temperature of individual U.S. cities. We term this the Weather Variance Risk Premia (WVRP). By constructing the WVRP measure from the CME’s weather futures and options contracts, we examine the role of weather variance risk on bond credit spreads of local corporations and municipalities. Our results indicate informativeness of weather derivatives market as a local risk factor priced in the bond returns of local corporations and municipalities. Our result is robust to controlling state level economic uncertainty measures.
We show that increasing energy risks endogenously decrease firms' investments, impacting expected returns. We empirically confirm this hypothesis in the cross-section of firms' capital expenditures and stock prices. We find that firms' exposure to energy risks differs from their exposure to crude oil returns or volatility, that not all energy risks are alike to investors, and that the negative comovement between energy risks and investments in the data is consistent with investors' specific preferences on uncertainty resolution. We document the important effects of information flows between partially segmented markets, as investors use relevant information from the commodity market to rebalance their equity portfolios.
We introduce a novel measure of weather risk implied from weather options' contracts. WIVOL captures risks of future temperature oscillations, increasing with climate uncertainty about physical events and regulatory policies. We find that shocks to weather volatility increase the likelihood of unexpected costs: a one-standard deviation change in WIVOL increases quarterly operating costs by 2%, suggesting that firms, on average, do not fully hedge exposures to weather risks. We estimate returns' exposure to WIVOL innovations and show that more negatively exposed firms are valued at a discount, with investors demanding higher compensations to hold these stocks. Firms' exposure to local but not foreign WIVOL predicts returns, which confirms the geographic nature of weather risks shocks.
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.
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.
Digesting FOREXS: Information Transmission across Asset Classes and Return Predictability (with Joon Woo Bae and Zhi Da), Accepted, Management Science
Blame it on the weather: Market implied weather volatility and firm performance (with Joon Woo Bae, Yoontae Jeon and Stephen Szaura)
Corporate Hedging, Investment, and Higher Moments of Stock Returns (with Hitesh Doshi and Praveen Kumar)
Financial Frictions and Loan Spreads, Revise and Resubmit, Journal of Financial and Quantitative Analysis