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Working Paper
Specification analysis of structural credit risk models
In this paper we conduct a specification analysis of structural credit risk models, using term structure of credit default swap (CDS) spreads and equity volatility from high-frequency return data. Our study provides consistent econometric estimation of the pricing model parameters and specification tests based on the joint behavior of time-series asset dynamics and cross-sectional pricing errors. Our empirical tests reject strongly the standard Merton (1974) model, the Black and Cox (1976) barrier model, and the Longstaff and Schwartz (1995) model with stochastic interest rates. The double ...
Working Paper
Stock-Bond Return Correlation, Bond Risk Premium Fundamentals, and Fiscal-Monetary Policy Regime
We incorporate regime switching between monetary and fiscal policies in a general equilibrium model to explain three stylized facts: (1) the positive stock-bond return correlation from 1971 to 2000 and the negative one after 2000, (2) the negative correlation between consumption and inflation from 1971 to 2000 and the positive one after 2000, and (3) the coexistence of positive bond risk premiums and the negative stock-bond return correlation. We show that two distinctive shocks—the technology and investment shocks—drive positive and negative stock-bond return correlations under two ...
Working Paper
Jump-diffusion term structure and Ito conditional moment generator
This paper implements a Multivariate Weighted Nonlinear Least Square estimator for a class of jump-diffusion interest rate processes (hereafter MWNLS-JD), which also admit closed-form solutions to bond prices under a no-arbitrage argument. The instantaneous interest rate is modeled as a mixture of a square-root diffusion process and a Poisson jump process. One can derive analytically the first four conditional moments, which form the basis of the MWNLS-JD estimator. A diagnostic conditional moment test can also be constructed from the fitted moment conditions. The market prices of diffusion ...
Working Paper
Itô conditional moment generator and the estimation of short rate processes
This paper exploits the It's formula to derive the conditional moments vector for the class of interest rate models that allow for nonlinear volatility and flexible jump specifications. Such a characterization of continuous-time processes by the Ito Conditional Moment Generator noticeably enlarges the admissible set beyond the affine jump-diffusion class. A simple GMM estimator can be constructed based on the analytical solution to the lower order moments, with natural diagnostics of the conditional mean, variance, skewness, and kurtosis. Monte Carlo evidence suggests that the proposed ...
Working Paper
A framework for assessing the systemic risk of major financial institutions
In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro-macro model, takes into account dynamic ...
Working Paper
Ambiguity Aversion and Variance Premium
This paper offers an ambiguity-based interpretation of variance premium?the difference between risk-neutral and objective expectations of market return variance?as a compounding effect of both belief distortion and variance differential regarding the uncertain economic regimes. Our approach endogenously generates variance premium without imposing exogenous stochastic volatility or jumps in consumption process. Such a framework can reasonably match the mean variance premium as well as the mean equity premium, equity volatility, and the mean risk-free rate in the data. We find that about 96 ...
Working Paper
Stock return predictability and variance risk premia: statistical inference and international evidence
Recent empirical evidence suggests that the variance risk premium, or the difference between risk-neutral and statistical expectations of the future return variation, predicts aggregate stock market returns, with the predictability especially strong at the 2-4 month horizons. We provide extensive Monte Carlo simulation evidence that statistical finite sample biases in the overlapping return regressions underlying these findings can not ``explain" this apparent predictability. Further corroborating the existing empirical evidence, we show that the patterns in the predictability across ...
Working Paper
A study of the finite sample properties of EMM, GMM, QMLE, and MLE for a square-root interest rate diffusion model
This paper performs a Monte Carlo study on Efficient Method of Moments (EMM), Generalized Method of Moments (GMM), Quasi-Maximum Likelihood Estimation (QMLE), and Maximum Likelihood Estimation (MLE) for a continuous-time square-root model under two challenging scenarios--high persistence in mean and strong conditional volatility--that are commonly found in estimating the interest rate process. MLE turns out to be the most efficient of the four methods, but its finite sample inference and convergence rate suffer severely from approximating the likelihood function, especially in the scenario of ...