Knowledge that Transforms

Average delta hedged returns for Standard & Poor's 500 index options are large: −0.7% per day. When we decompose these option returns into intraday and overnight components, average close-to-open returns are −1% per day and open-to-close returns are positive, 0.3%. A similar return pattern holds for all maturity and moneyness categories and equity options. These positive intraday returns are particularly difficult to explain. However, our results are consistent with option prices’ failing to account for the well-known fact that stock volatility is substantially higher intraday than overnight. These findings help explain price formation in the options market.

We present a general equilibrium model of banks’ optimal capital structure where bankruptcy is costly and investors have heterogeneous endowments and incur a cost for participating in equity markets. We show that, besides its social benefits, capital regulation benefits bank shareholders when it resolves fire sales externalities but not when it acts as a tax on bank profits such as when used to control excessive leverage induced by deposit insurance. Furthermore, capital regulation widens the gap between the returns to bank shareholders and depositors and may reduce investments in projects in favor of storage.

The existing literature has shown that an increase in the demand for safe assets induces the private sector to create more of them. Focusing on repos backed by US Treasuries, I theoretically and empirically show that an increase in the demand for safe assets leads to a decrease in repos outstanding. Because Treasuries are safe assets, an increase in the demand for safe assets compresses their term premia, reducing incentives to issue repos. Thus, the sensitivity of private safe asset creation depends on whether the collateral backing them are safe assets themselves. The sensitivity of the Federal Reserve’s reverse repurchase agreement (RRP) operations has the same sign as existing studies.

We develop a model in which collateral serves to protect creditors from the claims of other creditors. We find that, paradoxically, borrowers rely most on collateral when pledgeability is high. This is when taking on new debt is easy, which dilutes existing creditors. Creditors thus require collateral for protection against possible dilution by collateralized debt. There is a collateral rat race. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment. There is a collateral overhang. Our results suggest that policies aimed at increasing the supply of collateral can backfire, triggering an inefficient collateral rat race. Likewise, upholding the absolute priority of secured debt can exacerbate the rat race.

Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-to-market, and, by extension, book-to-market, predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

Fiscal policy matters for bond risk premia. Empirically, government spending level and uncertainty predict bond excess returns, as well as term structure level and slope movements. Shocks to government spending level and uncertainty are also priced in the cross-section of bond and stock portfolios. Theoretically, government spending level shocks raise inflation when marginal utility is high, thus generating positive inflation risk premia (term structure level effect). Uncertainty shocks steepen the yield curve (slope effect), producing positive term premia. These effects are consistent with evidence from a structural vector autoregression. Asset pricing tests using model simulated data corroborate our empirical findings.

The capital asset pricing model (CAPM) performs poorly overall, as market risk (beta) is weakly related to 24-h returns. This is because stock prices behave very differently with respect to their sensitivity to beta when markets are open for trading versus when they are closed. Stock returns are positively related to beta overnight, whereas returns are negatively related to beta during the trading day. These day-night relations hold for beta-sorted portfolios and individual stocks in the US and internationally as well as for industry and book-to-market portfolios and cash flow and discount rate beta-sorted portfolios. In addition to the change in slope of returns with respect to beta, the implied risk-free rate differs significantly between night and day. Consistent with this, returns on US Treasury futures differ significantly between night and day.

We study how sophisticated investors, when faced with shocks to information environment, change their information acquisition and trading behavior, and how these changes in turn affect market efficiency. We find that, after exogenous reductions of analyst coverage due to closures and mergers of brokerage firms, hedge funds scale up information acquisition, trade more aggressively, and earn higher abnormal returns on the affected stocks. The hedge fund participation also mitigates the impairment of market efficiency caused by coverage reductions. Overall, in a causal framework, our findings suggest a substitution effect between sophisticated investors and public information providers in facilitating market efficiency.

Using unique data at transaction and identity levels, we provide the first systematic study of interest rate swaps traded over the counter (OTC). We find substantial and persistent heterogeneity in derivative prices consistent with a pass-through of regulatory costs on to market prices via so-called valuation adjustments (XVA). A client pays a higher price to buy interest rate protection from a dealer (i.e., the client pays a higher fixed rate) if the contract is not cleared via a central counterparty. This OTC premium decreases by posting initial margins and with higher buyer’s creditworthiness. OTC premia are absent for dealers suggesting bargaining power.

We derive lower and upper bounds on the conditional expected excess market return that are related to risk-neutral volatility, skewness, and kurtosis indexes. The bounds can be calculated in real time using a cross section of option prices. The bounds require a no-arbitrage assumption, but they do not depend on distributional assumptions about market returns or past observations. The bounds are highly volatile, positively skewed, and fat-tailed. They imply that the term structure of expected excess holding period returns is decreasing during turbulent times and increasing during normal times and that the expected excess market return is on average 5.2%.