Louis R. Piccotti

Pricing Errors and the Geography of Trade in the Foreign Exchange Market

Pricing errors in exchange rates are largest during Asian trading hours and decrease until European–New York overlapping trading hours at which point the cycle begins again. Substantial heterogeneity exists in this pattern across exchange rates. Currencies have smaller pricing errors during their home trading hours, which can be explained by traders facing both lower information-unrelated costs and lower information-related costs during a currency׳s home trading hours. Using methods that are able to unambiguously identify the relative importance of information-related and information-unrelated costs for pricing errors, information-unrelated costs are of first-order importance while information-related costs are of second-order importance.

Information shares of two parallel currency options markets: Trading costs versus transparency/tradability

This paper studies whether trading costs or transparency/tradability are more important to price discovery using a unique dataset of currency options that trade simultaneously in two parallel markets. The Over-The-Counter (OTC) market is characterized by sophisticated investors, low trading costs, and low transparency/tradability compared to the Tel-Aviv Stock Exchange (TASE). Pricing errors are much larger on the TASE and the information share of the OTC market is significantly larger than that of the TASE by various information share measures, showing that trading costs and trader type have a first-order effect on price discovery while transparency/tradability have a second-order effect.

Financial Contagion Risk and the Stochastic Discount Factor

I provide evidence that financial contagion risk is an important source of the equity risk premium. Banks’ contributions to aggregate financial contagion are estimated in a state space framework and linked to systemic risk. Greater bank connectedness today leads to increased systemic risk 3–12 months later. More contagious banks earn significantly greater risk-adjusted returns than less contagious ones and the tradable high contagion-minus-low contagion bank portfolio is priced in the cross-section of stock returns. Stocks that co-move more strongly with contagious banks have greater expected returns. These results are robust to factor model specification, test assets, and time period considered.

Exploiting Closed-End Fund Discounts: A Systematic Examination of Alphas

We systematically study the value of the information contained in closed-end fund (CEF) premiums. We parametrically estimate CEF expected returns as a function of the history of CEF premiums, in addition to the current premium, and buy the quintile of funds with the highest expected returns and sell the quintile of funds with the lowest expected returns. The return on this portfolio suggests that previous studies, which examine the information in current premiums only, have understated the value of the information in premiums. Our strategy values the information in the history of CEF premiums at an annualized return of 18.2%.We find significant evidence of mean reversion in closed-end fund premiums. Previous studies understate the magnitudes of arbitrage profits. Capitalizing on mean reversion, we devise a parametric model to estimate expected fund returns. Our strategy of buying the quintile of funds with highest expected returns and selling the quintile of funds with lowest expected returns yields an annualized arbitrage return of 18.2% and a Sharpe ratio of 1.918, higher than corresponding figures produced using extant methods. Results are robust to a wide range of tests. They greatly deepen the puzzle and pose a challenge to market efficiency in these products. JEL Classification: G01, G11, G12

Order Flows, Differential Risk Premiums, and the UIP Puzzle

We jointly model purchasing power parity and uncovered interest rate parity (UIP) and show that violations to each stem from the same source. We test our model empirically using tick-by-tick customer-dealer quote data for 16 developed and emerging countries against the US dollar. Our results show that UIP violations are due to the existence of a risk premium in exchange rates as well as due to measurement error in using observed interest rate differentials as a function of the market’s expected return differentials. Using our combined macro-micro model substantially improves the fit of UIP.

Ambiguity Aversion and Asset Price Dynamics

We derive the equilibrium asset expected returns when there is ambiguity in asset expected returns, as well as ambiguity in asset return variances. In our model, ambiguity risk is systematic in nature and is non-diversifiable. Under regularity conditions, expected asset returns are linearly increasing in variance risk and ambiguity risk. We show that a beta pricing model can be derived from the equilibrium expected return function, which contains a systematic return factor and an ambiguity portfolio return factor, where the ambiguity portfolio weights are determined within the model. We test our model empirically and we obtain the model-implied results.

Information Shares in a Two-Tier FX Market

Using several measures of information share, we examine price discovery across the inter-dealer and dealer-customer market tiers in the currencies market. In the spot market, the information share of the inter-dealer tier is higher than that of the dealer-customer one for non-financial sector trades and is lower than the dealer-customer tier for foreign investors’ sell trades. In the forward market, the dealer-customer tier generally has the greater information share at the dealer’s buy side. Our results indicate the market where customers’ trades are the most informative and demonstrate how exogenous events affect price discovery across markets and market tiers.

Portfolio Frequency Structures and Utility Mapping

I examine the optimal portfolio allocation for investors with risk frequency preferences. As an implication, the portfolio opportunity set can be uniquely constructed from a set of basis frequency structures. Factor model representations represent restrictions on the frequency structure space, which is equivalent to finding a linear combination of frequency structures that are required to price a portfolio. A portfolio’s alpha results from the frequency structure misalignment between the marginal investor and the factor model implied one.

Expected Returns and Capital Structure Adjustment

We explore the firm’s required return on equity when it has a target debt ratio (TDR). We show that a firm’s expected return is increasing in the product of the distance between its debt ratio (DR) from its TDR (E[TDR-DR]), its speed of adjustment, and the spread of its tax benefits of debt over its bankruptcy costs of debt. Our empirical tests validate that high distance firms’ returns outperform those of low distance firms.