Essays in Financial Economics
Liao, Gordon Yu
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AbstractMy dissertation is composed of three papers in financial economics. In the first essay, “Credit Migration and Covered Interest Rate Parity,” I document economically large and persistent discrepancies in the pricing of credit risk between corporate bonds denominated in different currencies. This violation of the Law-of-One-Price (LOOP) in credit risk is closely aligned with violations of covered interest rate parity in the time series and the cross-section of currencies. I explain this phenomenon with a model of market segmentation. Post-crisis regulations and intermediary frictions have severely impaired arbitrage in the exchange rate and credit markets each on their own, but capital flows, either currency-hedged investment or debt issuance, bundle together the two LOOP violations. Limits of arbitrage spill over from one market to another.
The second essay, joint with Robin Greenwood and Sam Hanson, studies theoretically how do large supply shocks in one financial market affect asset prices in other markets. We develop a model in which capital moves quickly within an asset class, but slowly between asset classes. While most investors specialize in a single asset class, a handful of generalists can gradually re-allocate capital across markets. Upon arrival of a supply shock, prices of risk in the impacted asset class become disconnected from those in others. Over the long-run, capital flows between markets and prices of risk become more closely aligned. While prices in the impacted market initially overreact to shocks, under plausible conditions, prices in related asset classes underreact. Our model suggests that the short-run price impact of a supply shock on different markets may not accurately reveal the long-run impact, which is often of greater interest to policymakers.
The final essay, joint with Robert Barro, develops a new options-pricing formula that applies to far-out-of-the money put options on the overall stock market when disaster risk is the dominant force, the size distribution of disasters follows a power law, and the economy has a representative agent with Epstein-Zin utility. In the applicable region, the elasticity of the put-options price with respect to maturity is close to one. The elasticity with respect to exercise price is greater than one, roughly constant, and depends on the difference between the power-law tail parameter and the coefficient of relative risk aversion, γ. The options-pricing formula conforms to data from 1983 to 2015 on far-out-of-the-money put options on the U.S. S&P 500 and analogous indices for other countries. The analysis uses two types of data—indicative prices on OTC contracts offered by a large financial firm and market data provided by OptionMetrics, Bloomberg, and Berkeley Options Data Base. The options-pricing formula involves a multiplicative term that is proportional to the disaster probability, p. If γ and the size distribution of disasters are fixed, time variations in p can be inferred from time fixed effects. The estimated disaster probability peaks particularly during the recent financial crisis of 2008-09 and the stock-market crash of October 1987.
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