Working Papers

The Low-Minus-High Portfolio and the Factor Zoo (2019), with D. Andrei, and J. Cujean

Abstract: Anomalies in the cross section of returns should not be regarded as evidence against the CAPM. Regardless whether the CAPM is rejected for valid reasons or by mistake, a single long-short portfolio will always explain, together with the market, 100% of the cross-sectional variation in returns. Yet, this portfolio need not proxy for fundamental risk. We show theoretically how factors based on valuation ratios (e.g, book-to-market), or on investment rates, can be proxies for this portfolio. More generally, the empiricist can uncover an infinity of proxies for this portfolio, thus unleashing the factor zoo.

A pdf version of the paper is available here.

The Risk and Return of Equity and Credit Index Options (2023), with H. Doshi, J. Ericsson, and S. B. Seo

Abstract: We estimate a structural model of equity and credit options using data on index default swap and physical equity index volatility. The model predicts reasonable time-series of levels, skew, and term-structures of equity- and credit-index implied volatilities out-of-sample. Furthermore, the model predictions for option expected returns closely match empirical estimates. Decomposing returns into asset, variance, and jump risks, we study the sources of risk-return compensation in both derivative markets. Credit-index option expected returns are higher in absolute terms and depend more on variance risk than their equity counterparts which are primarily impacted by systematic asset and jump risks.

A pdf version is available soon.

Understanding the Comovement between Corporate Bonds and Stocks: The Role of Default Risk (2023), with A. Dickerson, A. Jeanneret, and P. Mueller

Abstract: We show that firm default risk is the primary predictor of the comovement between corporate bond and stock returns, both in the cross-section and over time. Intuitively, bonds of less creditworthy firms behave more like the issuing firms’ stocks, resulting in higher future comovement. We find that investing in bonds and stocks of the most creditworthy firms significantly enhances diversification benefits and Sharpe ratios out-of-sample. We develop a structural model with stochastic asset variance that rationalizes these findings. The model is consistent with salient asset pricing and default risk moments and contributes to understanding the forces driving stock-bond comovement.

A pdf version will be available here.

A Unified Model of the Cross-Sections of Stock and Corporate Bond Returns (2023), with A. Dickerson, J. Ericsson, and P. Orlowski

Abstract: We develop a structural model of the firm and derive predictions about the factor structure of stocks and corporate bonds and their exposures to systematic risks. The model predicts that equity and debt are positively exposed to aggregate asset risk but differ in their exposures to aggregate variance and interest rates. It also illustrates the highly nonlinear pattern in exposures. We analyze the factor structure in the two markets using a regression version of the model with nonparametric exposures which account for nonlinearities. In the joint cross-section, the regression-model outperforms its benchmarks and helps reconcile the two markets’ return dynamics.

A pdf version will be available soon.