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Derivatives

Paper Session

Friday, Jan. 6, 2017 7:30 PM – 9:30 PM

Sheraton Grand Chicago, Chicago Ballroom X
Hosted By: American Finance Association
  • Chair: Jun Pan, Massachusetts Institute of Technology

Generalized Recovery

Christian Skov Jensen
,
Copenhagen Business School
David Lando
,
Copenhagen Business School
Lasse Pedersen
,
Copenhagen Business School, New York University, and AQR Capital Management, LLC

Abstract

We characterize when physical probabilities, marginal utilities, and the discount rate can be recovered from observed state prices for several future time periods. We make no assumptions of the probability distribution, thus generalizing the time-homogeneous stationary model of Ross (2015). Recovery is feasible when the number of maturities with observable prices is higher than the number of states of the economy (or the number of parameters characterizing the pricing kernel). When recovery is feasible, our model is easy to implement, allowing a closed-form linearized solution. We implement our model empirically, testing the predictive power of the recovered expected return and other recovered statistics.

Informed Trading and Option Prices: Evidence From Activist Trading

Pierre Collin-Dufresne
,
Swiss Federal Institute of Technology-Lausanne
Vyacheslav Fos
,
Boston College
Dmitriy Muravyev
,
Boston College

Abstract

Using a comprehensive sample of trades from Schedule 13D filings by activist investors, we show that both directional and volatility information is reflected in stock and option prices. Option prices reflect the adverse selection risk associated with the volatility component of private information rather than the directional component. We then study the role of informed trading in price discovery and find that activists choose to trade stocks and to not trade derivatives in about 98% of cases. When they use derivatives, they typically seek to increase their overall economic exposure to the stock. We find that on days when activists accumulate shares, option implied volatility decreases and volatility skew increases. We conclude that informed trading in the stock market contributes to the flow of volatility information into option prices.

Option-Based Credit Spreads

Christopher Culp
,
Johns Hopkins University
Yoshio Nozawa
,
Federal Reserve Board
Pietro Veronesi
,
University of Chicago

Abstract

We propose a non-parametric empirical benchmark for credit risk analysis. We build fictitious “pseudo firms” that purchase real traded assets by issuing equity and zero-coupon bonds. By no-arbitrage, these bonds equal Treasuries minus put options on the firms’ assets, whose values are all observable. We exploit our pseudo firms as a laboratory, and empirically show that their credit spreads are large and countercyclical, illiquidity and corporate frictions are unlikely determinants of bonds’ credit spreads, infrequent rating changes and idiosyncratic asset uncertainty greatly increase spreads, and, in a banking application, discount rate shocks substantially increase banks’ tail risks and default correlations.
Discussant(s)
Stephen Ross
,
Massachusetts Institute of Technology
Marcin Kacperczyk
,
Imperial College London
Hui Chen
,
Massachusetts Institute of Technology
JEL Classifications
  • G1 - Asset Markets and Pricing