We examine the role of entropy risk in explaining the cross-section of commodity returns motivated by a theoretical model. We show that the commodity's entropy, a summary of all higher moments of returns, captures the dispersion of the stochastic discount factor and therefore affects expected excess returns. We compute entropy risk premiums as the difference between the physical and risk-neutral measures of entropy, estimated from the commodity futures and options market. We form entropy-based portfolios, and find that commodities with high ex-ante entropy risk premium have higher subsequent returns. The results from the strategy hold after controlling for variance and skewness risk premiums, and are robust to global and commodity specific risk factors.
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.
Work in Progress
Energy risks carry systematic effects in the cross-section of equity portfolios and individual stocks. Using a recursive framework, we endogenously derive expected returns from investors' preferences for uncertainty and expectations about distress states of the economy, which we estimate from the crude oil options market. Increasing distress risks decrease firms' energy usage, triggering an amplification mechanism that impact expected returns. We empirically confirm this channel, stocks with lower exposure to energy risks exhibit higher returns months ahead, indicating that investors demand extra compensation to hold these assets. Energy risk exposure remains significant after controlling for stock market, commodity-specific and global risk factors, as well as abnormal media coverage. With the financialization of commodities stock return predictability increases, strengthening the commodity-equity markets link.
Financial Frictions and Loan Spreads, Revise and Resubmit, Journal of Financial and Quantitative Analysis