Decomposing the Term Structure of Swap Rates in Light of the Financial Crisis

Link to PDF File: Can Hedge Funds Time Market Liquidity
Antje Berndt, Carnegie Mellon University
Peter Ritchken, Case Western Reserve

We investigate the determinants of swap rates along the maturity spectrum by jointly modeling not only the term structure of Treasury, LIBOR and swap rates, but also the Overnight Indexed Swap (OIS) curve. Using OIS rates is key since they are widely viewed as close indicators of riskless rates among private counterparties that transact in collateralized markets. We examine how the relative importance of each swap rate component has changed since the crisis, and cast insight into the appropriate discount rates to use when pricing collateralized interest-rate sensitive derivatives. Our results will contribute to the ongoing debate on how best to regulate over-the-counter contracts.

Effective risk management requires that all liabilities be priced well. The increasing regulation of OTC derivatives contracts and especially their placement into central clearing houses will that that regulators and clearing officials be able to price them accurately.

What is Risk Neutral Volatility?

Link to PDF File: What is Risk Neutral Volatility
Stephen Figlewski, New York University

The project will focus on extracting and analyzing Risk Neutral Densities from S&P 500 index options, to explore the most important factors that determine risk neutral volatility. Three major issues will be addressed: (1) Does the market primarily use backward-looking or forward-looking information in forming probability expectations? (2) How does uncertainty about the future index level on expiration day evolve as time elapses? (3) What factors go into the risk neutralization process that turns expected probabilities into market prices? The answers will help both academics and practitioners better understand the actual process of option pricing in real world markets.

As financial engineering methods become more widely adopted by investment managers, knowing more about risk neutral distributions is of increasing important to managers. Risk neutral volatilities have the potential to provide market-based information about volatility.

Capital Structure, Derivatives and Equity Market Quality

Link to PDF File: Capital Structure, Derivatives and Equity Market Quality
Ekkehart Boehmer, University of Oregon
Sudheer Chava, Georgia Tech
Heather Tookes, Yale

We examine the implications of individual equity options, publicly traded corporate bonds and credit default swaps (CDS) for equity market quality. We find that firms with listed equity options have more liquid equity and more efficient stock prices. By contrast, firms with traded CDS contracts have less liquid equity and less efficient stock prices, especially when these firms or their capital structures are complex (i.e., hard to value). The impact of publicly traded bond markets is somewhat mixed. However, overall, the results imply a negative effect of related markets when those markets are tied to debt in firms’ capital structures.

Liquidity in the equity markets is of interest to anyone who trades equities, either as a part of an investment strategy, or as a hedge for other instruments that bear correlated credit risk. This study will help us understand the determinants of equity liquidity in the presence of markets that trade correlated credit risks.

Can Hedge Funds Time Market Liquidity?

Link to PDF File: Can Hedge Funds Time Market Liquidity
Charles Cao, Penn State University
Yong Chen, Virginia Tech
Bing Liang, University of Massachusetts
Andrew W. Lo, MIT

This paper examines how hedge funds manage their market risk according to changes in aggregate liquidity conditions. Using a large sample of hedge funds, we find strong evidence that managers possess the ability to time market liquidity. They increase (decrease) their portfolios’ market exposure when equity-market liquidity is high (low). This liquidity timing ability is asymmetric: managers reduce their portfolios’ market exposure significantly when market liquidity is extremely low, but do not increase the exposure when market liquidity is unusually high. Finally, investing in top liquidity timing funds can generate economically significant profits. The top timing funds subsequently outperform the bottom timing funds by 5-6% per year on a risk-adjusted basis.

The profitability of hedge funds and other active traders depends on the capacity of the market to bear their trades, and to allow them to quit if they so desire. According, we would expect that hedge funds would pay much attention to these issues, and in particular, that they should be able to identify and exploit time varying liquidity.

Macroeconomic Uncertainty, Difference in Beliefs, and Bond Risk Premia

Andrea Buraschi, Imperial College
Paul Whelan, Imperial College
Link to PDF File: Macroeconomic Uncertainty, Difference in Beliefs, and Bond Risk Premia

In this research project we will study empirically the implications of macroeconomic disagreement for the time variation in bond market risk premia. Sources of heterogeneity in the belief structure of the economy can affect equilibrium asset prices, and the dynamics of disagreement may generate a source of predictable variation in excess bond returns. We propose to use survey data on macroeconomic forecasts of fundamentals spanning interest rates, real aggregates and inflation variables at different horizons to build an empirically observable proxy to aggregate macroeconomic disagreement. The results from this research will be key for understanding how belief structure of the economy affect asset prices and how it differs from information contained in macroeconomic aggregates.

Differences in beliefs and uncertainty about the future have somewhat different implications for asset prices. Being able to separate these issues can help managers predict asset prices. This study will examine these questions by relating bond risk premia to dispersion in responses to surveys of macroeconomic forecasts.