[Previous research concludes that options are mispriced based on the high average returns, CAPM alphas, and Sharpé ratios of various put selling strategies. One criticism of these conclusions is that these benchmarks are ill suited to handle the extreme statistical nature of option returns generated by nonlinear payoffs. We propose an alternative way to evaluate the statistical significance of option returns by comparing historical statistics to those generated by option pricing models. The most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not inconsistent (i.e.,is statistically insignificant) relative to the Black-Scholes model or the Heston stochastic volatility model due to the extreme sampling uncertainty associated with put returns. This sampling problem can largely be alleviated by analyzing market-neutral portfolios such as straddles or deltahedged returns. The returns on these portfolios can be explained by jump risk premiums and estimation risk.]

[We analyze auctions for the settlement of credit default swaps (CDS) theoretically and evaluate them empirically. The requirement to settle in cash with an option to settle physically leads to an unusual two-stage process. In the first stage, participants affect the amount of the bonds to be auctioned off in the second stage. Participants in the second stage may hold positions in derivatives on the assets being auctioned. We show that the final auction price might be either above or below the fair bond price because of strategic bidding on the part of participants holding CDS. Empirically, we observe both types of outcomes, with undervaluation occurring in most cases. We find that auctions undervalue bonds by an average of 6% on the auction day. Undervaluation is related positively to the amount of bonds exchanged in the second stage of the auction, as predicted by the theory. We suggest modifications of the settlement procedure to minimize the underpricing.]

Exposures of expected future nominal depreciation rates to the current interest rate differential violate the UIP hypothesis in a pattern that is a nonmonotonic function of horizon. Forward expected nominal depreciation rates are monotonic. We explain the two patterns by simultaneously incorporating the weak form of PPP into a joint model of the stochastic discount factor, the nominal exchange rate, and domestic and foreign yield curves. Departures from PPP generate the first pattern. The risk premiums for these departures generate the second pattern. Thus, the variance of the stochastic discount factor is related to the real exchange rate.

We develop a three-factor no-arbitrage model for valuing mortgage-backed securities in which we solve for the implied prepayment function from the cross-section of market prices. This model closely fits the cross-section of mortgage-backed security prices without needing to specify an econometric prepayment model. We find that implied prepayments are generally higher than actual prepayments, providing direct evidence of significant macroeconomic-driven prepayment risk premiums in mortgage-backed security prices. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s quantitative easing programs.

Previous research concludes that options are mispriced based on the high average returns, CAPM alphas, and Sharpe ratios of various put selling strategies. One criticism of these conclusions is that these benchmarks are ill-suited to handle the extreme statistical nature of option returns generated by nonlinear payoffs. We propose an alternative way to evaluate the statistical significance of option returns by comparing historical statistics to those generated by option pricing models. The most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not inconsistent (i.e., is statistically insignificant) relative to the Black-Scholes model or the Heston stochastic volatility model due to the extreme sampling uncertainty associated with put returns. This sampling problem can largely be alleviated by analyzing market-neutral portfolios such as straddles or delta-hedged returns. The returns on these portfolios can be explained by jump risk premia and estimation risk.

We develop a three-factor no-arbitrage model for valuing mortgage-backed securities in which we solve for the implied prepayment function from the cross-section of market prices. This model closely fits the cross-section of mortgage-backed security prices without needing to specify an econometric prepayment model. We find that implied prepayments are generally higher than actual prepayments, providing direct evidence of significant macroeconomic-driven prepayment risk premiums in mortgage-backed security prices. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s quantitative easing programs. Received May 10, 2016; editorial decision September 22, 2017 by Editor Stijn Van Nieuwerburgh.

We propose testing asset pricing models using multihorizon returns (MHRs). MHRs effectively generate a new set of test assets that is endogenous to the model and that identifies a broad set of possible conditional misspecifications. We apply MHR-based testing to prominent linear factor models and show that these models typically do a poor job of pricing longer-horizon returns, with pricing errors that are similar in magnitude to the risk premiums they were designed to explain. We trace the errors to the conditional factor dynamics. Explicitly incorporating factor timing into the models often makes mispricing worse, thereby posing a challenge for future research.

Long-run asset pricing restrictions in a macro term structure model identify discretionary monetary policy separately from a policy rule. We find that policy discretion is an important contributor to aggregate risk. In addition, discretionary easing coincides with good news about the macroeconomy in the form of lower inflation, higher output growth, and lower risk premiums on short-term nominal bonds. However, it also coincides with bad news about long-term financial conditions in the form of higher risk premiums on long-term nominal bonds. Shocks to the rule correlate with changes in the yield curve’s level. Shocks to discretion correlate with changes in its slope.

We analyze auctions for the settlement of credit default swaps (CDS) theoretically and evaluate them empirically. The requirement to settle in cash with an option to settle physically leads to an unusual two-stage process. In the first stage, participants affect the amount of the bonds to be auctioned off in the second stage. Participants in the second stage may hold positions in derivatives on the assets being auctioned. We show that the final auction price might be either above or below the fair bond price because of strategic bidding on the part of participants holding CDS. Empirically, we observe both types of outcomes, with undervaluation occurring in most cases. We find that auctions undervalue bonds by an average of 6% on the auction day. Undervaluation is related positively to the amount of bonds exchanged in the second stage of the auction, as predicted by the theory. We suggest modifications of the settlement procedure to minimize the underpricing.