Volatility and Tail Risk
Sunday, Jan. 7, 2018 8:00 AM - 10:00 AM
- Chair: Nicola Fusari, Johns Hopkins University
A Hidden Markov Model of Leverage Dynamics, Tail Risk, and Value-momentum Correlation
AbstractMomentum strategies exhibit rare but dramatic losses (crashes), which we show are a result of the leverage dynamics of stocks in the momentum portfolio. When the economy is in a hidden turbulent state, associated with a depressed and volatile stock market, the short-side of the momentum portfolio becomes highly levered, and behaves like a call option on the market index portfolio, making momentum crashes more likely. We develop a hidden Markov model of the unobserved turbulent state that affects the joint returns of the momentum strategy and the market index portfolios. We find that the use of a combination of normal and Student's t-distributions for the hidden residuals in the model to construct the likelihood of the realized momentum and market index returns dramatically improves the model's ability to predict crashes. The same variable that forecasts momentum crashes also forecasts the correlation between momentum and value, two of the benchmark investment styles used in performance appraisal of quant portfolio managers. The correlation is negative only when the probability of the economy being in a turbulent state is high. The conditional correlation is zero otherwise, which is two thirds of the time. Half of the negative relationship between value and momentum is due to the leverage dynamics of stocks in the momentum portfolio. The other half is due to a hidden risk factor, likely related to funding liquidity identified in Asness et al. (2013), which emerges only when the economy is more likely to be in the turbulent state.
AbstractWe define and construct a credit-implied volatility (CIV) surface from the firm-by-maturity panel of CDS spreads. We use this framework to organize the behavior of corporate credit markets into three stylized facts. First, CIV exhibits a steep moneyness smirk. Second, the joint dynamics of credit spreads on all firms are captured by three interpretable factors in the CIV surface. Third, the cross section of CDS risk premia is fully explained by exposures to CIV surface shocks. We propose a structural model for joint asset behavior of all firms that is characterized by stochastic volatility and severe, time-varying downside tail risk in aggregate asset growth.
A Theory of Dissimilarity Between Stochastic Discount Factors
AbstractThis paper proposes a measure of dissimilarity between stochastic discount factors (SDFs) in
different economies. The SDFs are made comparable using the respective bond prices as the
numeraire. The measure is based on a probability distance metric, is dimensionless, synthesizes
features of the risk-neutral distribution of currency returns, and can be extracted from currency
option prices. Linking theory to data, our empirical implementation reveals a salient geographical
pattern in dissimilarity across 45 pairs of industrialized economies. We compare the dissimilarity
between SDFs derived from several international asset pricing models to the empirical analog,
offering a dimension to gauge models.
- G1 - General Financial Markets