Pricing mortgage-backed securities in a multifactor interest rate environment: a multivariate density estimation approach

Multivariate density estimation (MDE) suggests that mortgage-backedsecurity (MBS) prices can be well described as a function ofthe level and slope of the term structure. We analyze how thisfunction varies across MBSs with different coupons. An importantfinding is that the interest rate level proxies for the moneynessof the option, the expected level of prepayments, and the averagelife of the cash flows, while the term structure slope controlsfor the average rate at which these cash flows should be discounted.     

Ex Ante Bond Returns and the Liquidity Preference Hypothesis

We provide a formal test of the liquidity preference hypothesis (LPH), that is, the monotonicity of ex ante term premiums, using nonparametric estimates that do not require a structural model for conditional expected returns. Although the point estimates of the term premiums are consistent with previous conclusions in the literature regarding violations of the LPH, the test statistics are generally insignificant, even when powerful conditioning information is used. These results illustrate the importance of correctly accounting for correlations across maturities and of formally testing the inequality restrictions implied by the LPH.     

A tale of three schools: insights on autocorrelations of short-horizon stock returns

This article reexamines the autocorrelation patterns of short-horizonstock returns. We document empirical results which imply thatthese autocorrelations have been overstated in the existingliterature. Based on several new insights, we provide supportfor a market efficiency-based explanation of the evidence. Ouranalysis suggests that institutional factors are the most likelysource of the autocorrelation patterns.     

Partial Adjustment or Stale Prices? Implications from Stock Index and Futures Return Autocorrelations

We investigate the relation between returns on stock indicesand their corresponding futures contracts to evaluate potentialexplanations for the pervasive yet anomalous evidence of positive,short-horizon portfolio autocorrelations. Using a simple theoreticalframework, we generate empirical implications for both microstructureand partial adjustment models. The major findings are (i) returnautocorrelations of indices are generally positive even thoughfutures contracts have autocorrelations close to zero, and (ii)these autocorrelation differences are maintained under conditionsfavorable for spot-futures arbitrage and are most prevalentduring low-volume periods. These results point toward microstructure-basedexplanations and away from explanations based on behavioralmodels.     

Liquidity as a choice variable: a lesson from the Japanese government bond market

In Japan, almost identical government bonds can trade at largeprice differentials. Motivated by this phenomenon, we examinethe issue of the value of liquidity in markets for risklesssecurities. We develop a model of an issuer of bonds, a marketmaker, and heterogeneous investors trading in an incompletemarket. We show not only that divergent prices for similar securitiescan be sustained in a rational expectations equilibrium butalso that this divergence may be optimal from the perspectiveof the issuer. Price segmentation is possible because agentshave a desire to trade, but short-sale restrictions limit theirtrading strategies and prevent them from forcing bond pricesto be equal. Restricting the form of market making to excludeprice competition and unregulated profit maximization is alsonecessary to sustain price segmentation. The optimality of segmentationfrom the issuer's standpoint arises because of the issuer'sability to charge for the liquidity services provided to theinvestors.     

Do asset prices reflect fundamentals? Freshly squeezed evidence from the OJ market

The behavioral finance literature cites the frozen concentrated orange juice (FCOJ) futures market as a prominent example of the failure of prices to reflect fundamentals. In contrast, we show that when theory clearly identifies the fundamental, e.g., at temperatures close to or below freezing, a close link exists between FCOJ prices and that fundamental. Using a simple, theoretically motivated, nonlinear, state dependent model, we can explain approximately 50% of the return variation on days with freezing temperatures. Moreover, while these observations represent less than 4.5% of the winter sample, they account for two-thirds of the entire winter return variability.     

Optimal Risk Management Using Options

This article provides an analytical solution to the problem of an institution optimally managing the market risk of a given exposure by minimizing its Value-at-Risk using options. The optimal hedge consists of a position in a single option whose strike price is independent of the level of expense the institution is willing to incur for its hedging program. This optimal strike price depends on the distribution of the asset exposure, the horizon of the hedge, and the level of protection desired by the institution. Moreover, the costs associated with a suboptimal choice of exercise price are economically significant.