We derive the optimal investment policy of a risk-averse investor in a market where there is a textbook arbitrage opportunity, but where liabilities must be secured by collateral. We find that it is often optimal to underinvest in the arbitrage by taking a smaller position than collateral constraints allow. Even when the optimal policy is followed, the arbitrage portfolio typically experiences losses before the final convergence date. In fact, its initial performance may be indistinguishable from that of a conventional portfolio with a poor track record. These results have important implications for the role of arbitrageurs in financial markets.

This paper presents simple closed-form expressions for volatility futures and option prices and examines their implications for the characteristics of these securities. We show that the properties of these volatility derivatives are fundamentally different from those of conventional option and futures contracts. This analysis also provides insights into the role that volatility derivatives may play in managing and hedging volatility risk in financial markets.

How does the market value “toxic” structured-credit securities? We study the valuation of what is possibly the most toxic of all toxic assets: the equity tranche of a collateralized debt obligation (CDO). In theory, CDO equity should be similar in nature to bank stock since both represent residual claims on a portfolio of loans. We find CDO equity returns are much more related to stock returns than to fixed-income returns. CDO equity returns track the returns of financial stocks much more closely than any other industry. Nearly two-thirds of the variation in CDO returns can be explained by fundamentals.

We develop a closed-form general equilibrium model of stock index futures prices in a continuous-time economy with stochastic interest rates and market volatility. We show that futures prices implied by the model have very different properties from those of the cost of carry model. Using NYSE stock index futures data, we examine the restrictions imposed on futures prices by both the equilibrium and cost of carry models. Consistent with the equilibrium model, we find that stock index futures prices are related to market volatility and that their interest-rate sensitivity is a nonlinear function of contract maturity.

This article presents a simple yet powerful new approach for approximating the value of American options by simulation. The key to this approach is the use of least squares to estimate the conditional expected payoff to the optionholder from continuation. This makes this approach readily applicable in path-dependent and multifactor situations where traditional finite difference techniques cannot be used. We illustrate this technique with several realistic examples including valuing an option when the underlying asset follows a jump-diffusion process and valuing an American swaption in a 20-factor string model of the term structure.

We provide estimates of Treasury convenience premia across the entire term structure of Treasury bills, notes, and bonds over more than a quarter of a century and document a variety of key stylized facts about their time‐series and cross‐sectional patterns. These results raise concerns about the evolving nature of Treasury markets and suggest that investors may now place less weight on the traditional role of Treasury securities as liquid trading vehicles. These stylized facts provide empirical benchmarks that could help guide future theoretical and empirical work about the economics of safe assets in financial markets.

We present a new approach for estimating small business equity returns. This approach applies the Merton (1974) credit model to the returns on entrepreneurial business credit card debt securitizations and solves for the implied equity returns for the small businesses owned by the cardholders. The estimated small business equity premium is 10.74%. The standard deviation of small business equity returns is 56.37%. We validate the methodology by applying it to investment‐grade corporate bonds and recovering a public equity premium of 6.17%.

We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults cluster. A three‐factor portfolio credit model explains virtually all of the time‐series and cross‐sectional variation in an extensive data set of CDX index tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm‐specific default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5% over the next 30 years. Despite this, the market places substantial weight on deflation scenarios in which prices significantly decline over extended horizons. The market prices the economic tail risk of deflation similarly to other types of tail risks, such as corporate default or catastrophic insurance losses. We find that deflation risk is strongly negatively correlated with outcomes in the financial markets and with consumer confidence. Received January 26, 2015; editorial decision November 14, 2016 by Editor Leonid Kogan.

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5% over the next 30 years. Despite this, the market places substantial weight on deflation scenarios in which prices significantly decline over extended horizons. The market prices the economic tail risk of deflation similarly to other types of tail risks, such as corporate default or catastrophic insurance losses. We find that deflation risk is strongly negatively correlated with outcomes in the financial markets and with consumer confidence.