Intermediary Inventory Risk and the Pricing Kernel
When market makers are short index options in an intermediary-based pricing model, the pricing kernel is U shaped in market returns. The U shape is driven more by the inability of market makers to perfectly hedge returns that are large in absolute value and less by unhedgeable stochastic volatility risk. The model provides a joint explanation for historically observed U-shaped kernels, large jump risk premia for both upward and downward jumps in the market, and expensive out-of-the-money calls and puts. Changes in end-user demand since the financial crisis coincide with a disappearance of the U shape in the pricing kernel and a decrease in index option prices, as predicted by the model.
Award: Best paper in Options & Derivatives at FMA
Presentations: FMA, FTG Summer School, Rice
In a dynamic model of large traders who manage inventory risk, we show that a daily market closure coordinates liquidity. Some length of closure is welfare-improving relative to 24/7 trade, as the coordination of liquidity improves allocative efficiency, fully offsetting the costs of the closure. A long closure is optimal for traders in small markets, while traders in large markets would benefit from extending trading hours to near 24/7. A calibration of our model to several large equity exchanges that have proposed extending trading hours suggests that implementing such proposals would benefit traders.
Award: Best Paper Award Semifinalist at FMA
Presentations: FRA (upcoming), FMA, Microstructure Exchange, NFA, FTG Summer School, World Federation of Exchanges Webinar, Carnegie Mellon, Rice
Policy Comments and Media: Markets Media, Columbia Blue Sky Blog, SEC comment letter (cited in 24X response letter, SEC findings notice)
A model of portfolio choice and labor market search implies that individuals who own stocks should exhibit countercyclical search intensity. Empirically, the data indicate that countercyclical search by this group of individuals contributes significantly to the countercyclical aggregate labor market search documented in empirical studies, consistent with the model. Moreover, endogenous search intensity during unemployment hedges stock market risk, leading to higher optimal equity allocations. The ability to search on the job also induces higher optimal equity allocations, although this effect is weaker for high-wage workers who engage in less search.
Presentations: Rice
The Empirical Virtue of Complexity in Simple Economic Models
We show that the empirical virtue of complexity arises in simple economic models. We show that machine-learning estimates, in data simulated from well-known economic frameworks, are superior to those from simpler empirical models. Machine-learning empirical models more accurately estimate the true SDF than sort-based or regression-based methods. Moreover, machine-learning methods more accurately estimate firms’ SDF weights, thus providing a superior depiction of the economically important firm heterogeneity that the economic models were designed to explain.
Presentations: LSU Mardi Gras Finance Conference
Information Acquisition in a Dynamic Model with Price Impact
In standard dynamic models of strategic trade, splitting orders over time to minimize price impact is individually rational but harms liquidity and is socially costly. We show that this result is sensitive to the information structure when endogenous information acquisition is allowed for. In an environment in which traders strategically postpone trade to the period in which information shocks arrive, more traders are incentivized to acquire information, and price informativeness can improve, relative to an environment with less strategic delay. However, in an environment in which traders strategically postpone trade from the information-shock period to the later period, traders have less incentive to acquire information, and adverse selection can decrease, leading to an increase in welfare. These results suggest the interaction between strategic delay of trade and the timing of information shocks is central to understanding the welfare implications of market structures.
Works in Progress:
Dynamic Portfolio Construction in a Log-Linear Space (with James Sefton)
Option-Implied Equity Premium Bounds and the Risk-Return Tradeoff (with Kerry Back, Patrick Blonien, Kevin Crotty)