A Credit Risk Explanation of the Correlation between Corporate Bonds and Stocks (2025), with A. Dickerson, A. Jeanneret, and P. Mueller
Abstract: We develop a credit risk model to explain the correlation between stock and corporate bond returns. By jointly incorporating asset risk, stochastic volatility, and stochastic interest rates, the model generates a correlation that rises with default risk– consistent with the data. The model yields two novel predictions. First, a risk decomposition reveals that asset and interest rate risks are the primary drivers of this relationship, while variance risk plays a crucial role in matching key pricing and credit moments. Second, default risk robustly predicts future stock-bond correlation, and thereby the Sharpe ratio of portfolios combining stocks and bonds: portfolios of firms with lower default risk exhibit lower volatility due to enhanced diversification, which more than offsets the reduction in expected returns. Extensive empirical analysis supports these predictions, offering new insights into the joint dynamics of equity and credit markets and their implications for portfolio allocation.
A pdf version will be available here.
The risk and return of stocks and bonds (2025), with A. Dickerson, J. Ericsson, and P. Orlowski
Abstract: We study the joint dynamics of stock and corporate bond returns using a structural credit risk model, where unlevered asset returns and volatility are driven by systematic risk factors. The model captures key time-series features of stock and bond volatilities, leverage, and credit spreads at the market, industry, and firm levels. It produces return forecasts that exceed Martin’s lower bound for equities and exhibit larger spikes in downturns than the average credit spreads for bonds. These forecasts significantly predict realized returns, outperforming benchmarks. We find that systematic variance risk commands a substantially larger premium in corporate bonds relative to equities.
A pdf version will be available soon.
Systematic Variance Risk Everywhere in Equity Option Markets (2025), with A. Dickerson, K. Jacobs, and P. Orlowski
Abstract: We propose systematic variance risk as the primary factor for pricing the cross-section of equity option returns. Using a parsimonious two-factor model with time-varying risk premiums, we find pervasive negative variance risk premiums in index, stock, and ETF options, consistent with theory. The magnitudes of the risk premiums across markets and the cross-section of option returns are very plausible, highlighting the central and unifying role of (systematic) variance risk in option markets. We emphasize aspects of model specification and empirical implementation which play a critical role in establishing this stylized fact and may explain differences with existing findings.
A pdf version will be available soon.
Permanent 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.