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  5. Asset Pricing: Tail Risk
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Asset Pricing: Tail Risk

Paper Session

Sunday, Jan. 8, 2023 1:00 PM - 3:00 PM (CST)

Sheraton New Orleans, Rhythms III
Hosted By: American Finance Association
  • Chair: Ye Li, University of Washington

Sovereign Defaults and Currency Crashes: Insurance, Carry Trade, and Quanto

Ljubica Georgievska
,
University of California-Los Angeles

Abstract

To what extent are currency crashes linked to sovereign defaults? Measuring their relationship is notoriously difficult because these are rare disaster events. I take a novel approach. I learn about the risk-neutral distribution of rare currency crushes from prices of far out-of-the-money (FOM) foreign exchange (FX) options and about sovereign defaults from prices of credit default swaps. Intuitively, these FOM options reflect the market’s assessment of currency crash tail risks. I find that FOM puts can insure against sovereign credit risk, and vice versa, implying a strong link between currency crashes and sovereign defaults. The dynamics of this relationship explain two broad phenomena: the currency carry trade and why sovereigns pay different credit interest rates (usually lower) on local currency debt versus foreign currency otherwise equivalent debt, known as the “quanto spread.” However, I find puzzling evidence suggestive of segmentation between FOM foreign exchange options and sovereign credit markets during tranquil times. As a result, trading between the two markets generates a generous annual Sharpe ratio in excess of 7.2, which vanishes during times of crisis because the two markets begin to behave as if they are one.

The Case of the Disappearing Skewness

Matthieu Gomez
,
Columbia University
Valentin Haddad
,
University of California-Los Angeles
Erik Loualiche
,
University of Minnesota

Abstract

A well-known observation about firm-level returns is that they are positively
skewed. We show that this positive skewness has slowly disappeared towards the
end of the 20th century. In the 21st century, the distribution of idiosyncratic returns is symmetric. Using the entire cross-section of firms, we investigate possible
explanations for the source of this change. This inquiry leaves us with a puzzle:
none of the standard rationales behind the asymmetry of firm returns seem able
to explain this phenomenon. Instead, the disappearance of skewness is present in
firms of all types.

Measuring Time-Varying Disaster Risk: An Empirical Analysis of "Dark Matter" in Asset Prices

Matthew Baron
,
Cornell University
Wei Xiong
,
Princeton University
Zhijiang Ye
,
Princeton University

Abstract

To confront the challenge that disaster risk is "dark matter" in finance, we construct an objective measure of disaster risk, which is able to predict half of GDP crashes in a sample of 20 advanced economies between 1870 and 2021. Despite this significant predictability, we find no supportive, and often contradictory, evidence of higher predicted disaster risk being associated with a higher equity premium, volatility, or dividend/price ratio of the equity market index; higher corporate bond spreads, or higher term spreads. Our results suggest that the subjective disaster risk mirrored by asset prices lags objective disaster risk by two years.

The Cumulant Risk Premium

Albert Kyle
,
University of Maryland
Karamfil Todorov
,
Bank for International Settlements

Abstract

We develop a novel methodology to measure the risk premium of higher-order cumulants (closely related to the moments of a distribution) based on assets satisfying a single-factor setting. We show that single-factor linear pricing works only if the difference between physical and risk-neutral cumulants, which we call the cumulant risk premium (CRP), is zero. To illustrate our approach empirically, we study leveraged ETFs, which are assets with constant betas and exposure to a single factor only. We show that the CRP is different from zero across all assets studied: equities, bonds, commodities, currencies and volatility. We quantify the even-order CRP by developing a simple strategy of shorting ETFs with opposite betas. The strategy mimics liquidity provision, earns Sharpe ratios above one, and can be used as a simple gauge of global market stress in real time. Our results have implications not only for factor models but also for portfolio theory, momentum strategies, option pricing, hedge funds, and leverage in general.

Discussant(s)
Lukas Kremens
,
University of Washington
Chen Wang
,
University of Notre Dame
Mete Kilic
,
University of Southern California
Nancy Xu
,
Boston College
JEL Classifications
  • G1 - Asset Markets and Pricing