Andrea Buraschi

Correlation Risk and Optimal Portfolio Choice

In this paper we solve an intertemporal portfolio problem with correlation risk, using a new approach for simultaneously modeling stochastic correlation and volatility. The solutions of the model are in closed form and include an optimal portfolio demand for hedging correlation risk. We calibrate the model and find that the optimal demand to hedge correlation risk is a non negligible fraction of the myopic portfolio, which often dominates the pure volatility hedging demand. The hedging demand for correlation risk is larger in settings with high average correlations and correlation variances. Moreover, it is increasing in the number of assets available for investment as the dimension of uncertainty with regard to the correlation structure becomes proportionally more important. JEL classification: D9, E3, E4, G12

Liquidity risk and specialness

Abstract Repo contracts, the most important form of collateralized lending, are widely used by financial institutions and hedge funds to create short-selling positions and manage their leverage profile. Moreover, they have become the primary tool of money management and monetary control of several central banks, including the Bundesbank and the newly born European Central Bank. This paper is an empirical study of this market. More specifically, we study the extent to which the current term structure of long term “special” repo spreads discount the future collateral value (specialness) of Treasuries. We ask whether repo spreads embed a liquidity risk premium and whether such a risk premium is time-varying. We quantify the size of the average liquidity risk premium and we provide empirical evidence of the extent of its time-variation.

Economic Uncertainty, Disagreement, and Credit Markets

We study how the equilibrium risk sharing of agents with heterogeneous perceptions of aggregate consumption growth affects bond and stock returns. Although credit spreads and their volatilities increase with the degree of heterogeneity, the decreasing risk premium on moderately levered equity can produce a violation of basic capital structure no-arbitrage relations. Using bottom-up proxies of aggregate belief dispersion, we give empirical support to the model predictions and show that risk premia on corporate bond and stock returns are systematically explained by their exposures to aggregate disagreement shocks. This paper was accepted by Jerome Detemple, finance.

The Forward Valuation of Compound Options

The Black-Scholes (BS) model gives the value of a European option when the underlying follows a lognormal distribution with constant volatility. American options, however, require more elaborate procedures, typically coming from what amounts to an approximate solution to a “backward” partial differential equation. Time varying volatility is fairly easily accommodated for European options, so long as it is non-stochastic, but for American options things become more complicated. More complex derivatives, involving compound optionality, for example, can be solved for the simplest cases, but quickly get beyond easy application of current techniques, as complexity grows. In any case, the existing solutions are such that each option requires its own full valuation routine. In this rather remarkable article, Buraschi and Dumas develop a new technique, based on solving a forward equation, that greatly simplifies the entire process. The result is a valuation algorithm that easily handles time varying (non-stochastic) volatility, compound optionality and American exercise. Unlike the “backward” technique, their approach produces an entire valuation surface defined in terms of strike and time to maturity, given current date and stock price. This allows valuation of multiple options on the same underlying with essentially no more computation than pricing a single one.

The Cross-Section of Expected Stock Returns: Learning about Distress and Predictability in Heterogeneous Orchards

We study an equilibrium asset pricing model with several Lucas (1978) trees subject to persistent distress events, where the agent has incomplete information about the state of an underlying common factor and learns from the events occurring to each tree. Contrary to similar asset pricing models with learning in one-tree economies, we find that cross-sectional learning and distress events can reverse several implications and help to explain empirical equity premia and risk-free rate dynamics. We also find that learning helps to generate more realistic dispersion of cross-sectional expected returns, relative to pure aggregate consumption risk models with complete information and disaster risk. The model provides a simple setting to study the asset pricing implications of orchards in which the cash flow links among different trees are asymmetric and some trees are more exogeneous than others. This allows, among other things, to link reduced-form assumptions of cash-flow risk heterogeneity to the structural properties of the orchard. Finally, we show that the cash-flow connectivity of a firm in the orchard is linked to the slope of the dividend strip curve. Sectors whose dividend process is exogenous in the orchard have negatively sloped term structures of dividend swaps. The opposite holds for endogenous sectors.

The Geography of Risk Capital

We use the relative pricing of pairs of emerging market (EM) sovereign bonds issued in both dollars and euros to study capital markets frictions during periods of financial distress. While there is no evidence of mispricing before 2007, during the 2007–2008 crisis we document a persistent anomaly that resulted in segmented EM bond markets. The sign of mispricing varies cross-sectionally, depending on the domestic currency of funding banks, and its magnitude depends on the degree of fragility in wholesale funding markets. Neither liquidity nor short-selling constraints can account for this anomaly. We document the impact of non-conventional policy interventions.

The Economics of Donations and Enlightened Self-Interest

We use a unique dataset from the English National Opera to study what motivates individuals to donate. The data includes both attendance and benefits (granted and consumed) by all donors. We find that individuals clearly respond to incentives. However, only some individuals are motivated exclusively by private benefits. Some individuals are willing to fund public goods, even though they could free‐ride. Moreover, donors who attend special events or new productions develop loyalty and increase their donations over time. Finally, individuals are sensitive to social pressure and network connections. These results can help charities to refocus the design of their fund‐raising.

The Dynamics of Limits to Arbitrage: Evidence from International Cross-Sectional Data

We study empirically the dynamic properties of limits to arbitrage in the sovereign bond markets in a period of market distress. The recent credit crisis offers a unique opportunity to investigate the economic causes of limits to arbitrage. We first consider markets that were liquid pre-crisis, and use pairs of emerging market sovereign bonds issued in two foreign currencies, i.e. usd and euro. A simple theoretical arbitrage relationship links their credit spreads. While these spreads are within bid/ask bounds during normal economic conditions, they are severely violated during periods of financial stress. As an example, in December 2008, Brazil’s euro-denominated credit spreads on 10-year Eurobonds were nearly 35% higher than the same credit risk denominated in usd. In order to understand the causes of this anomaly, we construct an empirical proxy of limits to arbitrage (LtA) and run a comprehensive investigation about its economic and behavioral drivers during 2005 - 2010 period, including the liquidity and credit crises. We find that limits to arbitrage are time-varying and state-dependent. During the liquidity crisis, LtA are mainly driven by Funding factors (Secured Funding and Commercial Paper Issuance). During the credit crisis (starting around Lehman failure), LtA are driven mainly by Global Sentiment, Liquidity risk, and Global Macro risk factors. Shocks to fundamentals, both cash-flow and discount rate shocks, matter. During the latter period of credit stress, these determinants generate R 2 up to 77%. Our findings also suggest that the initial FED interventions, which targeted the unsecured funding market, have been ineffective in reducing limits to arbitrage.The Law of One Price suggests a simple arbitrage relationship that links prices of Treasury bonds when issued by the same issuer in different currency denominations. This relationship was widely violated during the 2007-2008 Financial Crisis. In this paper, we use international cross-sectional data on this phenomenon to learn about the relative importance of different models of limits to arbitrage. A key source of information is a unique dataset that provides details on the cost of borrowing and the inventory of lendable bonds at brokers-dealers. We focus on four main explanations of limits to arbitrage: (i) Liquidity risk, (ii) Short-selling constraints, (iii) Leverage constraints and funding costs, (iv) Institutional frictions in the context of a large macro demand and wealth shock. We find that bond specific liquidity costs and short-selling constraints have only a limited ability to explain the observed elevated basis. Instead, we find stronger evidence of an interaction between leverage constraints and funding costs in the presence of a large macro shock reducing the supply of risk capital. In addition, we find that the geographical distribution and concentration of bank holdings of these bonds help to explain cross-sectional differences in the Basis. Finally, we quantify the extent to which monetary policy interventions helped to reduce these frictions.

Speculation, Hedging, and Interest Rates

We study the properties of bonds in an economy with risk tolerant agents who are rationally induced to trade because they believe in different models for the dynamics of the economy. We show analytically that low risk aversion coupled with differences in beliefs can help rationalise several features of Treasury bond markets that the single agent paradigm finds difficult to reconcile. Empirically, we test predictions from the model using a large dataset on beliefs about fundamentals and find that: (i) shocks to disagreement lower short term interest rates; (ii) raise the slope of the yield curve; and (iii) predict expected excess bond returns.In this paper we study both theoretically and empirically the implications of macroeconomic disagreement for bond market dynamics. If there is a source of heterogeneity in the belief structure of the economy then differences in beliefs can affect equilibrium asset prices. Using survey data on a unique data set we propose a new empirically observable proxy to measure macroeconomic disagreement and find a number of novel results. First, consistent with a general equilibrium model, heterogeneity in beliefs affect the price of risk so that belief dispersion regarding the real economy, inflation, short and long term interest rates predict excess bond returns with R 2 between 21%43%. Second, macroeconomic disagreement explains the volatility of stock and bonds with high statistical significance with an R 2 ∼ 26% in monthly projections. Third, disagreement also contains significant information trading activity: dispersion in beliefs explains the growth rate of open interest on 10 year treasury notes with R 2 equal to 21%. Fourth, while around half the information contained in the cross-section of expectations is spanned by the yield curve, there remains large unspanned component important for bond pricing. Finally, we control for an array of alternative predictor variables and show that the information contained in the belief structure of the economy is different from either consensus views or fundamentals. JEL classification: D9, E3, E4, G12

Understanding Short‐ versus Long‐Run Risk Premia

This paper studies the link between short‐ and long‐run risk premia. We extract short‐term risk premia from contemporaneous information on short‐term futures and cash equity markets under the assumption of no arbitrage. Predictability regressions reveal that short‐term risk premia capture different information from long‐run risk premia. Counter to the intuition that a high price of risk commands high returns, high short‐run risk premia on dividend claims predict low returns on the index. While inconsistent with models featuring either habit persistence or long‐run risk, the results may be reconciled with some models of uncertainty aversion.