Francis A. Longstaff

Dynamic Asset Allocation with Event Risk

Major events often trigger abrupt changes in stock prices and volatility. We study the implications of jumps in prices and volatility on investment strategies. Using the event-risk framework of Duffie, Pan, and Singleton (2000), we provide analytical solutions to the optimal portfolio problem. Event risk dramatically affects the optimal strategy. An investor facing event risk is less willing to take leveraged or short positions. The investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends both dynamic and buy-and-hold strategies. Jumps in prices and volatility both have important effects. Copyright 2003 by the American Finance Association.

A nonlinear general equilibrium model of the term structure of interest rates

Abstract We derive and test an alternative closed-form general equilibrium model of the term structure within the Cox, Ingersoll, and Ross theoretical framework in which yields are nonlinear functions of the risk-free rate. We show that equilibrium bond prices and the risk-free rate are not always inversely related and that bond risk need not be strictly increasing in maturity. Using Hansens generalized method of moments to obtain parameter estimates, this nonlinear model outperforms the Cox, Ingersoll, and Ross square root model in describing actual Treasury bill yields for the 1964–1986 period.

Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe

We study the nature of systemic sovereign credit risk using CDS spreads for the U.S. Treasury, individual U.S. states, and major European countries. Using a multifactor affine framework that allows for both systemic and sovereign-specific credit shocks, we find that there is considerable heterogeneity across U.S. and European issuers in their sensitivity to systemic risk. U.S. and Euro systemic shocks are highly correlated, but there is much less systemic risk among U.S. sovereigns than among European sovereigns. We also find that U.S. and European systemic sovereign risk is strongly related to financial market variables. These results provide strong support for the view that systemic sovereign risk has its roots in financial markets rather than in macroeconomic fundamentals.

The Relative Valuation of Caps and Swaptions: Theory and Empirical Evidence

Although traded as distinct products, caps and swaptions are linked by no-arbitrage relations through the correlation structure of interest rates. Using a string market model framework, we solve for the correlation matrix implied by the swaptions market and examine the relative valuation of caps and swaptions. The results indicate that swaption prices are generated by four factors and that implied correlations are generally lower than historical correlations. We find evidence that long-dated swaptions are priced inconsistently and that there were major distortions in the swaptions market during the hedge-fund crisis of late 1998. We also find that cap prices periodically deviate significantly from the no-arbitrage values implied by the swaptions market.

The term structure of very short-term rates: New evidence for the expectations hypothesis ☆

Empirical researchers have frequently rejected the expectations hypothesis. The expectations hypothesis, however, has seldom, if ever, been tested at the extreme short end of the term structure where maturities are measured in days or weeks. Using overnight, weekly, and monthly repo rates, I find that term rates are almost unbiased estimates of the average overnight rate. This evidence provides new support for the expectations hypothesis.

Valuing futures and options on volatility

This paper derives 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 options 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.

The Market Price of Risk in Interest Rate Swaps: The Roles of Default and Liquidity Risks

We study how the market prices the default and liquidity risks incorporated into interest rate swap spreads. We jointly model the Treasury, repo, and swap term structures using a five-factor affine framework and estimate the model by maximum likelihood. The credit spread is driven by a persistent liquidity process and a rapidly mean-reverting default intensity process. The credit premium for all but the shortest maturities is primarily compensation for liquidity risk. The term structure of liquidity premia increases steeply, while that of default premia is almost flat. Both liquidity and default premia vary significantly over time.

Bid-Ask Spreads and Trading Activity in the S&P 100 Index Options Market

This paper examines the cross-sectional distribution of bid-ask spreads in the S&P 100 index options market. Cross-sectional differences in bid-ask spreads are found to be directly related to differences in market-making costs and trading activity across options. We also examine the relation of an options bid-ask spread and trading activity to the spread and trading activity in other options. Call option trading activity is inversely related to the call option bid-ask spread but positively related to the spread of the put option having the same strike price and maturity, and vice versa. These findings suggest that traders view call and put options as substitutes.

Valuing Credit Derivatives

redit derivatives are potentially one of the most important new types of financial products introduced during the past decade. Many investors C have portfolios with values that are highly sensitive to shifts in the spread between risky and riskless yields, and credit derivatives offer these investors an important new tool for managing and hedging their exposure to this type of risk. In this article, we develop a simple framework for valuing derivatives on credit spreads. It captures the major empirical properties of observed credit spreads in that in allows for spreads to be stationary and meanreverting. We then use this framework to derive simple closed-form solutions for the prices of call and put options on the credit spread. These closed-form solutions have a number of interesting implications for the pricing and hedging properties of credit derivatives. We show that calls and puts on the credit spread can have prices below their intrinsic value. We also show that credit spread calls can have negative convexity, and that the delta of the call can be higher for out-of-the-money and at-the-money calls than for in-the-money calls. In addition, we show that the deltas of both calls and puts converge to zero as the time until expiration increases, which implies that long-term credit derivatives may have little abdity to hedge against current shifts in credit spreads.

Throwing away a billion dollars: the cost of suboptimal exercise strategies in the swaptions market

A machine for grinding objects, especially helical-or coil-type springs whose opposite ends are to be ground, includes a pair of rotary grinding discs having grinding surfaces spaced in axial direction from each other so as to define a work station. A plate-shaped element having a region mounted for turning movement relative to the work station intermediate the grinding surfaces is formed with a plurality of apertures, each of which is adapted to receive an object which is to be ground by contact with the grinding surfaces. Channels are provided in the plate-shaped element and connect the apertures with a source of fluid for supplying the latter to the apertures.