The paper investigates the portfolio allocation effects of increased asset co-movements during market downturns. We develop a model for the stock price process that allows for increased and asymmetric dependence between extreme return realizations. We isolate the portfolio hedging demands that arise due to extreme co-movements and find a substantial shift of the portfolio holdings toward the risk-free asset. We demonstrate that accounting for dependence between extreme events in portfolio decisions leads to significant economic gains that stem primarily from intertemporal hedging motives. These findings are robust along alternative modeling assumptions of extreme co-movements and conditional correlation.

A closet indexer is more likely to meet a value-weighted investment benchmark by value weighting the portfolio. Following this intuition, we introduce a simple measure of active management, the absolute difference between the value weights and actual weights held by a fund, summed across its holdings. This proxy captures managerial skill: active funds outperform passive ones by 2.5% annually. Compared with known measures of skill, our proxy robustly predicts fund flows, asset growth, factor-adjusted performance, and value added. Its predictive ability is orthogonal to that of other measures and is robust to controlling for volatility timing, past performance, and style.

We test the conditional consumption-CAPM using asset holders’ consumption and find that the time variation in the prices of asset holders’ consumption risk is procyclical. This puzzling time variation is at odds with the implication of existing consumption-based equilibrium asset pricing models. We show that our finding is a salient feature of the data observed in multiple asset classes (aggregate equity market, equity portfolios, bond portfolios, and commodities portfolios), using different measures of consumption (household survey data and high-frequency retail shopping data) and alternative empirical methodologies.

Using detailed loan holding data of Collateralized Loan Obligations (CLOs), we document empirical evidence for the fire sale of leveraged loans due to leverage constraints on CLOs. Constrained CLOs are forced to sell loans downgraded to CCC or below, and thus loans widely held by constrained CLOs experience temporary price depreciation. This instability is exacerbated by diversification requirements. As the CLO market grows, each CLO’s effort to diversify its portfolio leads to similarity in loan holdings among CLOs, and thus their leverage constraints simultaneously bind. CLOs’ overlapping loan holdings spread idiosyncratic shocks to large borrowers to the overall leveraged loan market.

The paper investigates the portfolio allocation effects of increased asset co-movements during market downturns. We develop a model for the stock price process that allows for increased and asymmetric dependence between extreme return realizations. We isolate the portfolio hedging demands that arise due to extreme co-movements and find a substantial shift of the portfolio holdings toward the risk-free asset. We demonstrate that accounting for dependence between extreme events in portfolio decisions leads to significant economic gains that stem primarily from intertemporal hedging motives. These findings are robust along alternative modeling assumptions of extreme co-movements and conditional correlation.

[We provide results for the valuation of European-style contingent claims for a large class of specifications of the underlying asset returns. Our valuation results obtain in a discrete time, infinite state space setup using the no-arbitrage principle and an equivalent martingale measure (EMM). Our approach allows for general forms of heteroskedasticity in returns, and valuation results for homoskedastic processes can be obtained as a special case. It also allows for conditional nonnormal return innovations, which is critically important because heteroskedasticity alone does not suffice to capture the option smirk. We analyze a class of EMMs for which the resulting risk-neutral return dynamics are from the same family of distributions as the physical return dynamics. In this case, our framework nests the valuation results obtained by Duan (1995) and Heston and Nandi (2000) by allowing for a time-varying price of risk and nonnormal innovations. We provide extensions of these results to more general EMMs and to discrete-time stochastic volatility models, and we analyze the relation between our results and those obtained for continuous-time models.]

Rather than assuming a fixed recovery rate in estimation, we estimate recovery rates from credit default swap spreads, using 3 years of daily data on 152 corporations. We use a quadratic pricing model, which ensures nonnegative default probabilities and recovery rates. The estimated cross section of recovery rates is plausible, with an average recovery rate of 54% and substantial cross-sectional variation. Estimated 5-year default probabilities are on average 67% higher than default probabilities obtained using the standard 40% recovery assumption. This finding critically impacts the valuation of structured credit products. Larger firms and firms with more tangible assets have higher recovery rates.

A growing body of evidence suggests that the benefits of international diversification via developed markets have declined dramatically. While emerging markets still offer diversification opportunities, their public equity indices capture only a fraction of emerging countries' economic activity. We propose a diversification approach that exploits the global connectedness of developed countries to gain exposure to emerging countries' overall economies rather than their shallow equity markets. In doing so, we demonstrate that developed markets still offer substantial diversification benefits beyond those available through equity indices. Our results suggest that relying on equity indices to assess diversification benefits understates diversification gains.

Financial relationships can alleviate the adverse effects of asymmetric information and agency costs on outside stakeholders. We examine announcement returns to PIPE transactions, conditional on the contract terms and identity of the investor. We find that the influence of contract terms on announcement returns depends on investor identity. For PIPEs with hedge fund investors, the inclusion of control terms associates with much larger announcement returns. In contrast, announcement returns for PIPEs, involving strategic investors, are less dependent on the existence of control terms. We find the opposite for liquidity terms. Namely, announcement returns are dramatically different for strategic investors with and without liquidity terms, while inclusion of liquidity terms is less influential when PIPEs involve hedge funds. Our findings suggest that investor identity and contract terms jointly influence market reactions to PIPEs.