Financial Frictions and Loan Spreads, Revise and Resubmit, Journal of Financial and Quantitative Analysis
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.
We study the risk premia embedded in the crude oil market. Risk premia depend on investors' anxiety and expectations about distress states of the economy. We estimate a forward-looking physical probability of distress using data from the crude oil options market. As the likelihood of a distress scenario increases, the total usage of oil for production purposes decreases, triggering an amplification mechanism that ultimately impacts on risk premia. Model-generated risk premia are highly time-varying, increase during periods of financial and geo-political turmoil, and decrease with the financialization of commodity markets. A preference for the early resolution of uncertainty is critical to capture the dynamics between investments and distress risks observed in the data. Risk premia cannot be explained by market wide factors, and estimated distress state probabilities help predict business conditions on top of benchmark covariates such as the US Treasury slope and VIX.
Pricing Soybean Futures and the Importance of Storage (with Stuart Turnbull and James Yae)
Work in Progress
Completed Working Papers
Willingness to Pay, Default Uncertainty, and Sovereign Risk
Entropy Risk Premia and Return Predictability in the Commodities Option Market (with Fousseni Chabi-Yo and Hitesh Doshi)
Economic and Financial Determinants of Credit Risk Premiums in the Sovereign CDS Market (with Hitesh Doshi and Kris Jacobs), Revise and Resubmit, Review of Asset Pricing Studies
We specify and estimate no-arbitrage models for sovereign CDS contracts by assuming that the country's default intensity depends on observable economic and financial indicators. We estimate these models using a sample of twenty-eight countries, three CDS maturities, and over a decade of daily data. The models provide a good fit. The impact of the economic and financial variables on spreads is consistent with economic intuition. Spreads increase as a function of stock market and exchange rate volatility, but decrease as a function of interest rates and stock market returns. The magnitudes of these impacts vary substantially across countries and over time. Estimated risk premiums are also highly time-varying and peak during the 2008 financial crisis for nearly all countries. For European countries, the risk premiums are also high during the Eurozone debt crisis. In periods of market stress and high CDS spreads, the increase in market risk premiums is even larger than the increase in default probabilities. The cross-sectional variation in risk premiums across countries is high, also in non-crisis periods.