Intermediary Risk and the Pricing Kernel
This paper studies pricing kernels in an intermediary-based index option pricing model. I show that when market makers net sell options, the pricing kernel is U-shaped in market returns. This result is driven primarily by the market maker's inability to perfectly hedge large movements in underlying returns. 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.
Are daily market closures still needed? In a model of large traders who manage inventory risk, we show that even short market closures can significantly improve liquidity. In a model of large traders who manage inventory risk, we show that traders engage in aggressive trading in anticipation of even a short market closure, which concentrates and coordinates liquidity. A market structure with a daily closure improves allocative efficiency relative to a continuously open market, even though traders cannot trade during the closure itself. If traders have heterogeneous information about the asset value, trade is less aggressive on the whole, but closure still retains its substantial welfare benefits. Our findings suggest moving to a longer trading day could be beneficial, but moving to 24/7 trading would harm welfare.
Policy Comments and Media: SEC comment letter, Columbia Blue Sky Blog, Markets Media
Works in Progress:
Labor Market Search and Portfolio Risk
Dynamic Portfolio Construction in a Log-Linear Space - with James Sefton
Performance of Factor Models in a Simple Economy - with Kerry Back and Seth Pruitt
Option-Implied Equity Premium Bounds and the Risk-Return Tradeoff - with Kerry Back, Patrick Blonien, Kevin Crotty