Knowledge that Transforms

This paper provides novel insights into the dynamic properties of variance and semivariance premia. Considering nine international stock market indices, we find consistent evidence of significantly negative total and downside (semi)variance premia of around -15 bps per month. These premia almost exclusively compensate investors for the risk of extreme negative returns. We also document pronounced downside semivariance premia for longer times to maturity, while the term structure of the total variance premium is upward sloping for all of the considered indices. The slope is driven by upside semivariance premia which are positive over long horizons. They can only be negative in adverse states, characterized by high uncertainty and high risk aversion. We show that a general equilibrium model featuring external habit formation and “bad environment-good environment” dynamics for consumption and dividends can explain many of these stylized facts and highlight the economic mechanisms.

We examine the effect of increased customer industry competition on relationships with suppliers, using exogenous variation in industry-level tariffs. We find that customers facing significant tariff reductions increase output by increasing product purchases and maintaining longer relationship durations with existing suppliers. These results are concentrated in strategically important suppliers such as those that have stronger prior relationship ties to customers and among those suppliers that are financially constrained due to capacity constraints among suppliers. However, customers who increase purchases from financially constrained suppliers perform poorly in the post-tariff reduction period. Overall, our results indicate that an increase in customer industry competition improves suppliers’ bargaining power and has both intended and unintended consequences for customers’ trading relationships and future performance.

Government support to banks through the provision of explicit or implicit guarantees affects the willingness of banks to take on risk by reducing market discipline or by increasing charter value. We use an international sample of rated banks and find that government support is associated with more risk taking by banks. More importantly, we find that restricting banks’ range of activities ameliorates the link between government support and bank risk taking. We conclude that, in the presence of moral hazard induced by government support, reducing bank complexity strengthens market discipline.

We utilize a fundamentals-based component volatility model to forecast the short-run volatility of exchange rate changes using monetary fundamentals quoted at different frequencies. Specifically, we allow the component volatility model to distinguish short-run exchange rate fluctuations from long-run movements that are directly linked to monetary fundamentals. Relative to more traditional time series volatility models, we find significant improvements in the ability to forecast the daily volatility of exchange rate changes by incorporating the monthly monetary fundamentals’ volatilities as predictors into the component volatility model. In the utility-based comparisons, we find that an investor is willing to pay a positive annual management fee of 5.72% on average to switch from the benchmark model to the fundamentals-based models. Of these models, the model with the symmetric and homogeneous Taylor rule and interest rate smoothing obtains the highest positive annual management fee.

We propose a momentum strategy that operates within commodity futures curves. The diversified curve momentum strategy generates a significantly positive average excess return and a (annualized) Sharpe ratio of 1.28. The profitability of the strategy has increased markedly in the more recent years. These excess returns are difficult to reconcile with risk based explanations, as evidenced by the significantly positive alpha after controlling for exposure to several well-known risk factors. The average excess return on the diversified curve momentum strategy remains significantly positive even after accounting for transaction costs.

No-arbitrage dynamic term structure models (DTSMs) have regularly been used to estimate interest rate expectations and term premia, but are beset by empirical challenges. I propose augmenting DTSMs with overnight indexed swap (OIS) rates to better estimate the decomposition along the term structure at daily frequencies. A Gaussian affine DTSM, augmented with 3 to 24-month OIS rates, generates estimates of US expectations that closely correspond to survey-implied measures out to a 10-year horizon and are more stable across sub-samples, compared to existing models. In addition, I provide narrative evidence, in the form of an event study around US unconventional monetary policy announcements, to further exemplify the benefits from OIS augmentation.

We analyse the relationship between geopolitical risk and asset prices and show that geopolitical risk is distinct from existing measures of economic, financial, and political risk and that the response of precious metals to geopolitical risk differs considerably from that of other assets. Precious metals are hedges against geopolitical risk in general and geopolitical threats (as opposed to acts) in particular. Conversely, stocks and bonds respond negatively to geopolitical risk and geopolitical threats. For extreme geopolitical risks, only gold and silver display consistent safe haven properties. Our results show that holding precious metals within a diversified portfolio lowers the impact of geopolitical risk.

Co-lending by private-sector and government-owned lenders accounts for over one-tenth of all syndicated-loan funding to corporate borrowers from 1980 to 2010. Co-lending is often rationalized as a mean to impose market discipline on government-owned lenders. We investigate whether that is really the case, or whether political distortions affect “mixed” syndicates including both private and government-owned lenders. We find that mixed syndicates allocate more loans to government-connected firms than private syndicates do. Further, loans from mixed syndicates have lower spreads, longer maturities, less collateral, and fewer covenants. Terms are most favorable when borrowers are “connected.” Firms borrowing from mixed syndicates show a decline in profitability and valuation in subsequent years, suggesting loans are inefficiently allocated. The evidence is consistent with political distortions in mixed lending. Results are driven by domestic government lenders: loan by syndicates including foreign government-owned lenders resemble more closely private-sector loans, both in allocation and loan terms.

We analyze how the inflow of TARP funds in the wake of the 2007/2008 financial crisis impacted banks’ interbank market activity. We show that TARP banks’ interbank market activity was impacted in a statistically and economically significant way. Their interbank lending via federal funds sold increased by 77 percent relative to the mean of the control group of non-TARP banks. We further show that among the TARP banks, the most affected ones also increased credit risk taking, while at the same time not increasing profitability. These findings suggest a new, heretofore not investigated channel through which TARP may have increased banks’ moral hazard incentives.

We document that acquirer announcement returns decrease and takeover premiums increase with the length of time since targets’ initial public offerings. Declining asymmetric information that leads to lower target valuation uncertainty for the acquirer can explain these effects. Newly public targets have greater information asymmetry (relative to their established counterparts) making their valuation more uncertain for a less-informed acquirer. Risk-averse acquirer managers pay less for riskier targets, resulting in lower takeover premiums and higher acquirer announcement returns. Over time, as the target builds a public track record, the asymmetric information about its valuation declines and takeover premiums increase to the benefit (detriment) of target (acquirer) shareholders.