Jefferson Duarte

Nonparametric option pricing under shape restrictions

Frequently, economic theory places shape restrictions on functional relationships between economic variables. This paper develops a method to constrain the values of the first and second derivatives of nonparametric locally polynomial estimators. We apply this technique to estimate the state price density (SPD), or risk-neutral density, implicit in the market prices of options. The option pricing function must be monotonic and convex. Simulations demonstrate that nonparametric estimates can be quite feasible in the small samples relevant for day-to-day option pricing, once appropriate theory-motivated shape restrictions are imposed. Using S&P500 option prices, we show that unconstrained nonparametric estimators violate the constraints during more than half the trading days in 1999, unlike the constrained estimator we propose.

Risk and Return in Fixed Income Arbitrage: Nickels in front of a Steamroller?

We conduct an analysis of the risk and return characteristics of a number of widely used fixed income arbitrage strategies. We find that the strategies requiring more “intellectual capital” to implement tend to produce significant alphas after controlling for bond and equity market risk factors. We show that the risk-adjusted excess returns from these strategies are related to capital flows into fixed income arbitrage hedge funds. In contrast with other hedge fund strategies, we find that many of the fixed income arbitrage strategies produce positively skewed returns. These results suggest that there may be more economic substance to fixed income arbitrage than simply “picking up nickels in front of a steamroller.”

What Does the PIN Model Identify as Private Information

We show that the PIN and the Duarte and Young (2009) (APIN) models do not match the variability of noise trade in the data and that this limitation has severe implications for how these models identify private information. We examine two alternatives to these models, the Generalized PIN model (GPIN) and the Odders-White and Ready (2008) model (OWR). Our tests indicate that measures of private information based on the OWR and GPIN models are promising alternatives to the APIN’s Adj.PIN and PIN.

Residential Mortgage Credit Derivatives

As the fallout from subprime losses clearly demonstrates, the credit risk in residential mortgages is large and economically significant. To manage this risk, this article proposes the creation of derivative instruments based on the credit losses of a reference mortgage pool. We argue that these derivatives would enable banks to retain whole loans while also enjoying the capital benefits of hedging the credit risk in their mortgage portfolios. In comparisons of hedging effectiveness, the analysis shows that instruments based on credit losses outperform contracts based on house price appreciation.

Davids, Goliaths, and Business Cycles

We show that a simple, intuitive variable, GVD (Goliath versus David) reflects time-variation in discount rates related to changes in aggregate business conditions. GVD is the annual change in the weight of the largest 250 firms in the aggregate stock market, and is motivated by research that shows that small firms are more severely impacted than large firms by economic shocks due to differences in access to external finance. We find that GVD is the best single predictor of market returns out-of-sample among traditional predictors, predicting quarterly market returns with an out-of-sample R2 of 6.3% in the 1976--2011 evaluation period.

How Does Failure Spread Across Broker-Dealers and Dealer Banks?

We empirically test for the presence of two types of financial contagion across large broker-dealers and dealer banks during the crisis of 2007-2009: the type based on the idea that market illiquidity mediates the spread of distress from one dealer to others, or, “liquidity contagion”, and the type based on the idea that one dealer’s distress directly undermines the franchise value of others, or, “franchise value contagion”. We test for the two types of contagion against the null hypothesis that correlation in dealer-distress during the crisis was only due to an observable common shock to the real estate assets that triggered the crisis. We find evidence that prior to the Federal Reserve and Treasury market interventions in the Fall of 2008, both types of contagion were present. Franchise-value contagion, however, dominates, accounting for 95% of all contagion. Furthermore, unlike liquidity contagion which disappears after the interventions are in place, franchise-value contagion remains.

To Lend or Not to Lend: Revealed Attitudes towards Gender, Ethnicity, Weight, and Age in the U.S.

This paper investigates attitudes towards gender, ethnicity, weight, and age in the U.S. from peer-to-peer credit markets. With detailed data on both the lending decision and loan performance, we are substantially better able to distinguish between taste based discrimination consistent with Becker (1957) and statistical discrimination than extant studies which suffer from significant correlated omitted variable problems.On the one hand, our results suggest that women, African Americans, and older people receive favorable treatment. On other hand, we find significant taste-based discrimination against Hispanics, Asians, younger, and overweight people. Overall, these findings are consistent with a positive shift in attitudes towards women and African-Americans, at least among individual investors that participate in peer-to-peer lending markets. At the same time, negative attitudes towards Hispanics, Asians, and possibly overweight people (still) exist.

Can the Common-Factor Hypothesis Explain the Observed Housing Wealth Effect?

The common-factor hypothesis is one possible explanation for the strong observed housing wealth effect. Under this hypothesis, house price appreciation is statistically related to changes in consumption as long as the available proxies for the common driver of housing and non-housing demand are noisy and housing supply is not perfectly elastic. We simulate a model in which a common factor drives the relation between house prices and consumption to examine the extent to which the common-factor hypothesis can explain the observed housing wealth effect estimated with U.S. state-level data. Our results indicate that the common-factor hypothesis can easily explain the observed housing wealth effect even when the proxies for the common factor have small measurement errors.