Jason Zhanshun Wei

Corporate Yield Spreads and Bond Liquidity

We examine whether liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4000 corporate bonds and spanning investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads; and that an improvement of liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers’ fixed effect and potential endogeneity bias. Our finding mitigates the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants, and suggests that liquidity plays an important role in corporate bond valuation.

Finding Generators for Markov Chains via Empirical Transition Matrices, with Applications to Credit Ratings

In this paper we identify conditions under which a true generator does or does not exist for an empirically observed Markov transition matrix. We show how to search for valid generators and choose the “correct” one that is the most compatible with bond rating behaviors. We also show how to obtain an approximate generator when a true generator does not exist. We give illustrations using credit rating transition matrices published by Moodys and by Standard and Poors.

Option Market Liquidity: Commonality and Other Characteristics

This study examines option market liquidity using Ivy DBs OptionMetrics data. We establish convincing evidence of commonality for various liquidity measures based on the bid-ask spread, volumes, and price impact. The commonality remains strong even after controlling for the underlying stock markets liquidity and other liquidity determinants such as volatility. Smaller firms and firms with a higher volatility exhibit stronger commonalities in option liquidity. Aside from commonality, we also uncover several other important properties of the option markets liquidity. First, information asymmetry plays a much more dominant role than inventory risk as a fundamental driving force of liquidity. Second, the market-wide option liquidity is closely linked to the underlying stock markets movements. Specifically, the options liquidity responds asymmetrically to upward and downward market movements, with calls reacting more in up markets and puts reacting more in down markets.

A multi-factor, credit migration model for sovereign and corporate debts

Abstract This paper develops a multi-factor, Markov chain model for rating migrations and credit spreads that is applicable to both sovereign and corporate debts. The model’s central feature is to allow transition matrices to be time-varying and driven by rating specific latent variables which encompass economic factors like the business cycle. There are three main contributions. First, the model incorporates well-documented empirical properties of transition matrices such as their dependence on business/credit cycles, and it also allows for inter-rating variations in credit quality changes. Second, instead of focusing solely on empirical modeling of rating transitions, the paper also shows how the empirical model can be implemented for actual valuations. Third, the estimation and calibration procedures are easy to follow and implement.

Pricing Foreign Currency and Cross-Currency Options Under GARCH

Experience has shown that the returns volatility for most financial instruments is not constant, as assumed in the Black-Scholes model and similar valuation formulas. Rather, high-volatility and low-volatility days cluster together, and in many cases there is significant asymmetry between volatility movements in up and down markets. These regularities are well-represented by a GARCH model for the underlying assets returns, and the theory of option pricing under GARCH has been developed by Duan in earlier wok. Here, Duan and Wei extend the GARCH option pricing paradigm to contracts that are affected by multiple stochastic variables, such as a quanto option on a foreign stock that is exposed to risk from changes in both the stock price and the exchange rate. In addition to presenting new valuation formulas, the authors demonstrate that taking GARCH effects into account can help to resolve the pricing anomalies uncovered by earlier research using simpler models.

Trading Activity and Bid-Ask Spreads of Individual Equity Options

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid-ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60-90Â days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid-ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latters spread to narrow.

Weather Derivatives: A New Class of Financial Instruments

This paper is a concise introduction of the weather derivatives market. We present a brief survey of the market, describe the main products, and illustrate their usage in risk management. We also discuss the key issues in modeling and valuation. Finally, taking weather derivatives as an alternative asset class, we demonstrate their potentials in asset allocation and portfolio management.

A Simple Approach to Bond Option Pricing

Many authors have derived closed-form formulas for European options on discount bonds within a one-factor interest rate framework. The only known formula for European options on coupon-paying bonds is given by Jamshidian (1989), which is in the form of a portfolio of options on discount bonds. Not only does this approach require pricing of more than one options, it also requires that a threshold interest rate level be solved iteratively. When there are many coupons or when pricing is needed more frequently, Jamshidians approach can be costly. In this paper, we show a very simple approach to pricing European options on bond portfolios. We not only do away with the requirement of calculating iteratively the threshold level of interest rate, but also reduce the calculation to only one option price. It also dramatically simplifies hedging. The key of this approach is to use a single discount bond to approximate the bond portfolio by matching durations.

Precipitation Modeling and Contract Valuation: A Frontier in Weather Derivatives

This article has two objectives. First, it describes the market for precipitation derivatives and provides examples of applications of such contracts. Second, it proposes, estimates, and compares several models for precipitation. Based on the data for Chicago Midway Airport (1950–2003), we find that a mixture of exponentials and kernel density provide a better fit than a gamma distribution. A valuation example is also presented.

Valuing Differential Swaps

A pricing model is derived for a new type o f interest rate swap, a dgerential swap. The model is based on meanreverting Omstein-Uhlenbeck processes for the domestic and the foreign risk-jee interest rates and a lognormal process for the exchange rate. We use the standard risk-neutral valuation technique, but we identify a change o f measure that allows us to work directly with the risk-neutral process f o r theforeign interest rate. The technique can also be applied to other similarJinam’a1 instruments such as foreign interest rate-driven, domestic currency-denominated bonds (Robinson 119911). The model can be easily extended to yield curve models such as Hull and White 119921. The results o f simulations indicate that the correlations (between the domestic and the foreign interest rates and between the foreign interest rate and the exchange rate) play a key role in the pricing o f dgerential swaps.