We introduce the nonlinear arbitrage correction (NAC), the residual that renders a linear benchmark model arbitrage-free while preserving the law of one price. The price of NAC captures the marginal Sharpe ratio increase consistent with no-arbitrage and upper-bounds the constrained Hansen–Jagannathan distance. Using four decades of international equity, currency, and factor returns, NAC is strongly countercyclical, peaking during crises when linear models turn negative. The implied Sharpe ratio increase reaches 0.3, underscoring its economic relevance. While linear models perform well on average, they fail in distressed states, underpricing nonlinear payoffs. Incorporating NAC restores positivity and stabilizes pricing across regimes.

This paper introduces a model free decomposition of S&P 500 forward market index returns in terms of realized and implied dispersion, downside, and tail risk using option portfolios. The decomposition lends itself by construction to learn about the different sources of risk in the market return and subsequently to visual and formal diagnosing of asset pricing models. It utilizes a novel conditional frequency analysis on the basis of available options rather than the times series of the S&P 500. Empirically, downside risk accounts for most of the forward market return, while symmetric tail risk is not prominently featured. The predictable, persistent part of the realized return is small. Nevertheless, signals revealed by this risk anatomy provide predictive out of sample power for realized returns, in particular for longer maturities. Furthermore, it indicates that models with identically and independently distributed state variables are generally misspecified in this market, and that care must be taken when calibrating disaster risk models. A formal test based on the risk anatomy rejects a model with time-varying disaster intensity.

This paper develops an optimal trading strategy explicitly linked to an agent׳s preferences and assessment of the distribution of asset returns. The price of this strategy is a portfolio of implied moments, and its expected excess returns naturally accommodate compensation for higher-order moment risk. Variance risk and the equity premium approximate it to first order and it nests cross-sectional asset pricing models such as the linear Capital Asset Pricing Model (CAPM). An empirical study in the US index market compares the investment behavior of an agent with recursive long-run risk preferences to one who merely uses an identically independently distributed time series model and takes market prices as given. The two agents exhibit very similar behavior during crises and can be distinguished mostly during calm periods.

[We develop a new method for measuring moment risk premiums. We find that the skew premium accounts for over 40% of the slope in the implied volatility curve in the S&P 500 market. Skew risk is tightly related to variance risk, in the sense that strategies designed to capture the one and hedge out exposure to the other earn an insignificant risk premium. This provides a new testable restriction for asset pricing models trying to capture, in particular, disaster risk premiums. We base our results on a general trading strategy by replicating contracts that swap implied for realized conditional asset moments.]

We study a model for portfolio selection under uncertainty along with market equilibria that are associated with the optimal positions. Allowing for both ambiguity-seeking and ambiguity-averse market participants, model-implied demand functions resemble observed bid–ask spreads, and are consistent with extant limited-participation results based on more specialized ambiguity settings. A Pareto-efficient second-best equilibrium arises from constraining the portfolio allocations of ambiguity seekers. It implies that heterogeneity in ambiguity preferences is sufficient for mutually beneficial transactions even among all else homogeneous traders. Our results reconcile many observed phenomena in liquid high-information financial markets, such as portfolio inertia and negative risk premia.

Using an extensive cross-section of US corporate CDS this paper offers an economic understanding of implied loss given default (LGD) and jumps in default risk. We formulate and underpin empirical stylized facts about CDS spreads, which are then reproduced in our affine intensity-based jump-diffusion model. Implied LGD is well identified, with obligors possessing substantial tangible assets expected to recover more. Sudden increases in the default risk of investment-grade obligors are higher relative to speculative grade. The probability of structural migration to default is low for investment-grade and heavily regulated obligors because investors fear distress rather through rare but devastating events. (authors' abstract)

Under mild assumptions, we recover the model‐free conditional minimum variance projection of the pricing kernel on various tradeable realized moments of market returns. Recovered conditional moments predict future realizations and give insight into the cyclicality of equity premia, variance risk premia, and the highest attainable Sharpe ratios under the minimum variance probability. The pricing kernel projections are often U ‐shaped and give rise to optimal conditional portfolio strategies with plausible market timing properties, moderate countercyclical exposures to higher realized moments, and favorable out‐of‐sample Sharpe ratios.

We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.

We develop a new method for measuring moment risk premiums. We find that the skew premium accounts for over 40% of the slope in the implied volatility curve in the S&P 500 market. Skew risk is tightly related to variance risk, in the sense that strategies designed to capture the one and hedge out exposure to the other earn an insignificant risk premium. This provides a new testable restriction for asset pricing models trying to capture, in particular, disaster risk premiums. We base our results on a general trading strategy by replicating contracts that swap implied for realized conditional asset moments.

This paper shows that low‐risk anomalies in the capital asset pricing model and in traditional factor models arise when investors require compensation for coskewness risk. Empirically, we find that option‐implied ex ante skewness is strongly related to ex post residual coskewness, which allows us to construct coskewness factor‐mimicking portfolios. Controlling for skewness renders the alphas of betting‐against‐beta and betting‐against‐volatility insignificant. We also show that the returns of beta‐ and volatility‐sorted portfolios are driven largely by a single principal component, which in turn is explained largely by skewness.