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.
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.
Financial Frictions and Loan Spreads, Revise and Resubmit, Journal of Financial and Quantitative Analysis
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.
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.
Published and Accepted Papers
Work in Progress
Digesting FOREXS (with Joon Woo Bae and Zhi Da), Accepted, Management Science
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.
Willingness To Pay and Default Risk
The Low Energy Investor: Energy Risks, Investments and Stock Returns
Corporate Hedging, Investment, and Higher Moments of Stock Returns (with Hitesh Doshi and Praveen Kumar)