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APT-5: Crash Risk
Credit and Option Risk Premia
1Carnegie Mellon University, United States of America; 2Arizona State University; 3University of Washington
We estimate a structural model of credit risk to quantify the impact of time-varying bankruptcy costs and risk on credit spreads. To identify these channels, the estimation relies on information in firm-level CDS rates and option prices. While CDS rates are sensitive to both time-varying bankruptcy costs and risk, equity option prices are only sensitive to risk because equity holders lose everything in bankruptcy. Our model features a representative agent with recursive preferences and Markov-switching states for the drift and volatility of consumption and earnings growth. The dynamics for consumption and earnings feature persistent and rare economic disasters, which are crucial for the valuation of CDS and option contracts. Firms issue debt trading off tax benefits and bankruptcy costs, refinance when their interest coverage ratio is too high, and optimally default when their interest coverage ratio is too low. A structural decomposition reveals that time-variation in bankruptcy costs account for 3% and time-variation in risk for 75% of the level of credit spreads.
The Dynamics of the Implied Volatility Surface
1HEC Montréal, Canada; 2University of Texas at Dallas
The term structure of the implied volatility is upward-sloping in good and normal times but downward-sloping in bad times. In addition, the implied volatility features a negative skew in bad times, i.e., the implied volatility of out-of-the-money put options is larger than that of at-the-money options, while the implied volatility resembles more to a smile as economic conditions improve. These findings are robust features of the U.S. and international option markets. An asset-pricing model with rare disasters followed by recoveries can explain the aforementioned empirical regularities. By contrast, ignoring post-disaster recoveries generates predictions that are inconsistent with the data.
Downside Risks and the Price of Variance Uncertainty
1University of Münster, Germany; 2University of Zurich, Switzerland
This paper studies the role of generalized disappointment aversion (GDA) in reconciling several asset-pricing puzzles in models of long-run risks. To fully capture the nonlinearities introduced by these preferences, we solve the model globally with projection. This allows us to scrutinize the channels through which GDA unfolds. A key feature of our calibrated model is the significant wedge GDA drives between the physical and the risk-neutral measure. The model captures not only the size of the variance risk premium (VRP), but also the hump-shaped predictability pattern and the prominent role of downside risks for the VRP and its predictive power.
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Conference: EFA 2019
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