Andrea Vedolin

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.

Short-Run Bond Risk Premia

In the short-run, bond risk premia exhibit pronounced spikes around major economic and financial crises. In contrast, long-term bond risk premia feature cyclical swings. We empirically examine the predictability of the market variance risk premium—a proxy of economic uncertainty—for bond risk premia and we show the strong predictive power for the one month horizon that almost entirely disappears for horizons above one year. The variance risk premium is largely orthogonal to well-established bond return predictors—forward rates, jumps, yield curve factors, and macro variables. We rationalize our empirical findings in an equilibrium model of uncertainty about consumption and inflation which is coupled with recursive preferences. We show that the model can quantitatively explain the levels of bond and variance risk premia as well as the predictive power of the variance risk premium while jointly matching salient features of other asset prices.

Bond Variance Risk Premiums

This paper studies variance risk premiums in the Treasury market. We first develop a theory to price variance swaps and show that the realized variance can be perfectly replicated by a static position in Treasury futures options and a dynamic position in the underlying. Pricing and hedging is robust even if the underlying jumps. Using a large options panel data set on Treasury futures with different tenors, we report the following findings: First, the term structure of implied variances is downward sloping across maturities and increases in tenors. Moreover, the slope of the term structure is strongly linked to economic activity. Second, returns to the Treasury variance swap are negative and economically large. Shorting a variance swap produces an annualized Sharpe ratio of almost two and the associated returns cannot be explained by standard risk factors. Finally, the returns remain highly statistically significant even when accounting for transaction costs and margin requirements.

Interest Rate Risk Management in Uncertain Times

We revisit evidence of real effects of uncertainty shocks in the context of interest rate uncertainty. We document that adverse movements in interest rate uncertainty predict significant slowdowns in real activity, both at the aggregate and at the firm levels. To understand how firms cope with interest rate uncertainty, we develop a dynamic model of corporate investment, financing, and risk management and test it using a rich data set on corporate swap usage. We find that interest rate uncertainty depresses financially constrained firms’ investments in spite of hedging opportunities, because risk management by means of swaps is effectively risky. Received December 11, 2016; editorial decision January 26, 2018 by Editor Itay Goldstein. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web Site next to the link to the final published paper online.Uncertainty about the future path of interest rates is associated with a significant slowing of future economic activity both at the aggregate and firm level. Using a large data set on firms’ interest rate swap usage, we find that 1) interest rate risk management helps firms attenuate the adverse effects of interest rate uncertainty on investment and 2) there are significant crosssectional differences in swap usage according to asset and financing risk. To interpret these findings, we develop a dynamic model of corporate interest rate risk management in the presence of investment and financing frictions.

Central Bank Communication and the Yield Curve

Using the institutional features of ECB monetary policy announcements, we provide direct evidence for the risk premium channel of central bank communication. We show that on days when the ECB announces its monetary policy almost all of the variation of bond yields is driven by communication. Moreover, while the effect of monetary policy is homogeneous across countries before the European debt crisis, we document dramatic differences post crisis and show that communication shocks drive a wedge between peripheral and core yields. We empirically link the periphery-core wedge to break-up and credit risk premia, and study this channel theoretically through the lens of an equilibrium model in which central bank communication reveals information about the state of the economy.