In the presence of jump risk, expected stock return is a function of the average jump size, which can be proxied by the slope of option implied volatility smile. This implies a negative predictive relation between the slope of implied volatility smile and stock return. For more than four thousand stocks ranked by slope during 1996–2005, the difference between the risk-adjusted average returns of the lowest and highest quintile portfolios is 1.9% per month. Although both the systematic and idiosyncratic components of slope are priced, the idiosyncratic component dominates the systematic component in explaining the return predictability of slope. The findings are robust after controlling for stock characteristics such as size, book-to-market, leverage, volatility, skewness, and volume. Furthermore, the results cannot be explained by alternative measures of steepness of implied volatility smile in previous studies.

[This paper examines the relationship between default probability and stock returns. Using the Expected Default Frequency (EDF) of Moody' s KMV, we document that higher default probabilities are not associated with higher expected stock returns. Within a model of bargaining between equity holders and debt holders in default, we show that the relationship between default probability and equity return is (i) upward sloping for firms where shareholders can extract little benefit from renegotiation (low "shareholder advantage") and (ii) humped and downward sloping for firms with high shareholder advantage. This dichotomy implies that distressed firms with stronger shareholder advantage should exhibit lower expected returns in the cross section. Our empirical evidence, based on several proxies for shareholder advantage, is consistent with the model's predictions.]

Robert Z. Aliber, Bhagwan Chowdhry, Shu Yan; Some Evidence that a Tobin Tax on Foreign Exchange Transactions May Increase Volatility *, European Finance Re

We use a novel pricing model to imply time series of diffusive volatility and jump intensity from S&P 500 index options. These two measures capture the ex ante risk assessed by investors. Using a simple general equilibrium model, we translate the implied measures of ex ante risk into an ex ante risk premium. The average premium that compensates the investor for the ex ante risks is 70% higher than the premium for realized volatility. The equity premium implied from option prices is shown to significantly predict subsequent stock market returns.

We study linear-quadratic term structure models with random jumps in the short rate process where the jump arrival rate follows a stochastic process. Empirical results based on the US data show that incorporating stochastic jump intensity significantly improves model fit to the dynamics of both interest rate and volatility term structure. Our results also show that jump intensity is negatively correlated with interest rate changes and the average size is larger on the downside than upside. Examining the relation between jump intensity and macroeconomic shocks, we find that at monthly frequency, jumps are neither triggered by nor predictive of changes in macroeconomic variables. At daily frequency, however, we document interesting patterns for jumps associated with information shocks.

This paper examines the relationship between default probability and stock returns. Using the Expected Default Frequency (EDF) of Moody's KMV, we document that higher default probabilities are not associated with higher expected stock returns. Within a model of bargaining between equity holders and debt holders in default, we show that the relationship between default probability and equity return is (i) upward sloping for firms where shareholders can extract little benefit from renegotiation (low “shareholder advantage”) and (ii) humped and downward sloping for firms with high shareholder advantage. This dichotomy implies that distressed firms with stronger shareholder advantage should exhibit lower expected returns in the cross section. Our empirical evidence, based on several proxies for shareholder advantage, is consistent with the model's predictions.

This paper documents significant cross-return predictability of news variables, derived from textual analysis of news articles, for a broad cross-section of currencies. By employing forecasts based on the Least Absolute Shrinkage and Selection Operator (LASSO) that incorporate both news variables and forward discounts, we develop a notably profitable trading strategy. This strategy proves robust against transaction costs, risk adjustments, and controls for currency characteristics. Further analyses indicate that both risks and market frictions contribute to the profitability of the trading strategy, highlighting the crucial role of news in financial markets.

In Das et al. (2010), an agent divides his or her wealth among mental accounts that have different goals and optimal portfolios. While the moments of the distribution of asset returns are exogenous in their normative model, they are endogenous in our corresponding positive model. We obtain the following results. First, there are multiple equilibria that we parameterize by the implied risk aversion coefficient of the agent’s aggregate portfolio. Second, equilibrium asset prices and the composition of optimal portfolios within accounts depend on this coefficient. Third, altering the goal of any given account affects the composition of each portfolio.