Term Structure Of Risk Research Articles

Term Structure of Risk in Expected Returns

Abstract This paper develops a methodology to test structural asset pricing models based on their implications for the multiperiod risk-return trade-off. A new measure, the term structure of risk, captures the sensitivities of multiperiod expected returns to structural shocks. The level and slope of the term structure of risk can indicate misspecification in equilibrium models. I evaluate the performance of asset pricing models with long-run risk, consumption disasters, and variance shocks. I find that only a model with multiple shocks in the variance of consumption growth is consistent with the propagation of and compensation for risk in the aggregate stock market.

Quadratic Hedging of Futures Term Structure Risk in Merchant Energy Trading Operations

Quadratic Hedging of Futures Term Structure Risk in Merchant Energy Trading Operations

Corporate Policies and the Term Structure of Risk

We build a dynamic corporate finance model with heterogeneity in the pricing and in the firm's exposure to aggregate risks. All else equal, we show that if long-term (persistent) shocks have a higher market price than short-term (temporary) shocks, firms shorten the horizon of corporate policies, favoring payouts over investment. In the cross section, this effect is stronger for firms more exposed to long-term shocks, but can be reversed for firms more exposed to short-term shocks. Our analysis is extended to embed time variation in risk prices over the business cycle, motivated by recent evidence on the term structure of equity.

A novel market efficiency index for energy futures and their term structure risk premiums

This paper proposes a novel futures market efficiency index which aggregates the efficiencies of futures contracts across their term structure spanning from one month to 12 months. The index measures the ability for price discovery of a long-term futures contract on its nearby short-term contract consistently across its terms. The index uses a recently developed futures market efficiency test which accounts for heteroscedastic prices and time-varying risk premiums. It simultaneously estimates the term premiums of futures, providing valuable information for the investor. The proposed index is employed to investigate the efficiencies of four major energy commodities, namely, crude oil, natural gas, heating oil, and gasoil during the sample period 1990–2016. Numerical results indicate that the market efficiencies vary across terms and across energy commodities. Gasoil futures traded on the Intercontinental Exchange (ICE) are the most efficient and natural gas futures are the least efficient in prices. The spillover dynamics of market risk information across futures markets are investigated using conditionally heteroscedastic common factors (CHCFs) extracted for each commodity using the estimated term premiums. There exist significant delayed, contemporaneous, and potential information spillovers among term premiums of the energy commodities in our sample. Our findings are robust and they can help investors to optimally diversify their portfolios.

Term Structure of Risk in Expected Returns

This article develops an empirical methodology to determine which economic shocks span risk in asset returns and fluctuations in discount rate and cash flow news. A theoretically motivated shock identification scheme in a present-value model identifies economic shocks. The choice of identifying restrictions is based on the properties of the term structure of risk in expected returns in the data and in equilibrium models. Empirically, I relate equity discount rate news and cash flow news to multiple sources of risk in the variance of consumption growth. Both types of news are almost equally important for the aggregate market risk.

Corporate Finance Practices in Sri Lanka

The aim of this study was to investigate the use of corporate finance practices in terms of capital budgeting, cost of equity capital and capital structure in Sri Lanka. A comprehensive primary survey was conducted of 38 out of 150 financial officers of companies listed on the Colombo Stock Exchange (CSE) in Sri Lanka. Stratified random sampling was used to select the participants in order to represent the different sectors in CSE. Collected data were then analyzed by applying mean and percentage analysis. Results of the survey revealed that NPV was the most frequently ?always? cited capital budgeting method, followed by IRR and PB. CAPM was the most preferred method to calculate the cost of equity capital followed by average historical rate of return on common stock. Remarkably, most firms would use a discount rate for entire company to evaluate the project. Further, it was evaluated that how finance professionals make adjustments for risk factors. It was concluded that risk of unexpected inflation, interest rate risk, term structure risk, business cycle risk, size based risk, market to book ratio and momentum were mostly adjusted by discount rate while commodity price risk, foreign exchange risk and distress risk were mostly adjusted by cash flow. Further, this study was to find out whether Sri Lankan finance professionals behave as expected by pecking order theory of capital structure patterns. Findings of the study are in line with the pecking order theory that firms are having preference to internal finance for their capital. This research has proffered a more reliable and comprehensive analysis of corporate finance practices in Sri Lankan companies.

Long vs. short term asymmetry in volatility and the term structure of risk

This short paper introduces the distinction between short and long term asymmetric effects in volatilities. With short term asymmetry we refer to the conventional one, i.e. the asymmetric response of current volatility to the most recent return shocks. In addition, we argue that there may be asymmetries with respect to the way the effect of past return shocks propagate over time. We refer to this as long term asymmetry and propose a model that enables the study of the potential occurrence of such a feature. In an empirical application using stock market index data we find evidence of the joint presence of short and long term asymmetric effects and demonstrate important implications for risk predictions. In particular, positive return shocks is ascribed substantial significance for long term risk prediction.

The Effects of Long Memory in Price Volatility of Inventories Pledged on Portfolio Optimization of Supply Chain Finance

Due to the illiquidity of inventories pledged, the essential of price risk management of supply chain finance is to long-term price risk measure. Long memory in volatility, which attests a slower than exponential decay in the autocorrelation function of standard proxies of volatility, yields an additional improvement in specification of multi-period volatility models and further impact on the term structure of risk. Thus, long memory is indispensable to model and measure long-term risk. This paper sheds new light on the impact of the existence and persistence of long memory in volatility on inventory portfolio optimization. Firstly, we investigate the existence of long memory in volatility of the inventory returns, and examine the impact of long memory on the modeling and forecasting of multi-period volatility, the dependence structure between inventory returns and portfolio optimization. Secondly, we further explore the impact of the persistence of long memory in volatility on the efficient frontier of inventory portfolio via a data generation process with different long memory parameter in the FIGARCH model. The extensive Monte Carlo evidence reveals that both GARCH and IGARCH models without accounting for long memory will misestimate the actual long-term risk of the inventory portfolio and further bias the efficient frontier; besides, through A sensitive analysis of long memory parameter d, it is proved that the portfolio with higher long memory parameter possesses higher expected return and lower risk level. In conclusion, banks and other participants will benefit from the long memory taken into the long-term price risk measure and portfolio optimization in supply chain finance.

Asset Pricing Implications of Volatility Term Structure Risk

I find that stocks with high sensitivities to changes in the VIX slope exhibit high returns on average. The price of VIX slope risk is approximately 2.5% annually, statistically significant and cannot be explained by other common factors, such as the market excess return, size, book-to-market, momentum, liquidity, market volatility, and the variance risk premium. I provide a theoretical model that supports my empirical results. The model extends current rare disaster models to include disasters of different lengths. My model implies that a downward sloping VIX term structure anticipates a potential long disaster and vice versa.

The Road to Retirement - Bumpy or Smooth, Depends on Your Route, January 2011

Defined Contribution (DC) plans are rapidly becoming the primary retirement investment vehicle for a majority of employees across the US and other markets around the globe. Asset allocation for DC plans has to strike a balance between growth and protection assets over the savings lifecycle while protecting the long-term purchasing power of the nest egg. Due to the long duration of retirement investing and various risks associated with it, implementing the right asset allocation has become critical and challenging for DC plans.The unique Risk Focused methodology presented in this paper aims to address the shortcomings of conventional Target Date Funds experienced during the 2008 financial crisis. The proposed approach addresses the cumulative impact of shortfall, sequence of returns, longevity, and market risks in determining asset allocation at different time horizons. This is accomplished by combining the term structure of risk, return, and covariance of asset classes with an explicit risk budget. The Risk Focused glide path potentially delivers comparable retirement wealth outcomes with enhanced downside protection, lower journey volatility, and attempts to facilitate a smoother journey on the road to retirement. Hence, the caption of the paper, Road to Retirement – Bumpy or Smooth, Depends on your Route.

Sharing Longevity Risk: Why Governments Should Issue Longevity Bonds

Government-issued longevity bonds would allow longevity risk to be shared efficiently and fairly between generations. In exchange for paying a longevity risk premium, the current generation of retirees can look to future generations to hedge their systematic longevity risk. Longevity bonds will lead to a more secure pension savings market, together with a more efficient annuity market. By issuing longevity bonds, governments can aid the establishment of reliable longevity indices and key price points on the longevity risk term structure and help the emerging capital market in longevity-linked instruments to build on this term structure with liquid longevity derivatives.

Rare Disasters, Credit, and Option Market Puzzles

We embed systematic default, procyclical recovery rates, and external habit persistence into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy can simultaneously explain several key empirical regularities in equity, credit, and options markets. Our model captures the empirical level and volatility of credit spreads, generates a flexible credit risk term structure, and provides a good fit to a century of observed spreads. The model also matches high-yield and collaterized debt obligation tranche spreads, equity market moments, and index option skewness. Finally, our model implies a time-varying relationship between bond and option prices that depends on the state of the economy and that explains the conflicting empirical evidence found in the literature. This paper was accepted by Jerome Detemple, finance.

STRATEGIC ASSET ALLOCATION FOR LONG‐TERM INVESTORS: PARAMETER UNCERTAINTY AND PRIOR INFORMATION

SUMMARYWe study the effect of parameter uncertainty on the long‐run risk for three asset classes: stocks, bills and bonds. Using a Bayesian vector autoregression with an uninformative prior we find that parameter uncertainty raises the annualized long‐run volatilities of all three asset classes proportionally with the same factor relative to volatilities that are conditional on maximum likelihood parameter estimates. As a result, the horizon effect in optimal asset allocations is much weaker compared to models in which only equity returns are subject to parameter uncertainty. Results are sensitive to alternative informative priors, but generally the term structure of risk for stocks and bonds is relatively flat for investment horizons up to 15 years. Copyright © 2013 John Wiley & Sons, Ltd.

Rare Disasters and Credit Market Puzzles

We embed systematic default, pro-cyclical recovery rates and habit persistence into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy can simultaneously explain several key empirical regularities in equity, credit, and options markets. Our model captures the empirical level and volatility of credit spreads, generates a fl‡exible credit risk term structure, and provides a good fi t to a century of observed spreads. The model also matches high-yield and CDO tranche spreads, equity market moments, and index option skewness. Finally, our model implies a time-varying relationship between bond and option prices that depends on the state of the economy and that explains the con‡flicting empirical evidence found in the literature.

Sharing Longevity Risk: Why Governments Should Issue Longevity Bonds

Government-issued longevity bonds would allow longevity risk to be shared efficiently and fairly between generations. In exchange for paying a longevity risk premium, the current generation of retirees can look to future generations to hedge their aggregate longevity risk. There are also wider social benefits. Longevity bonds will lead to a more secure pension savings market - both defined contribution and defined benefit - together with a more efficient annuity market resulting in less means-tested benefits and a higher tax take. The emerging capital market in longevity-linked instruments can get help to kick start market participation through the establishment of reliable longevity indices and key price points on the longevity risk term structure and can build on this term structure with liquid longevity derivatives.

The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment

This paper reviews alternative options for monetary policy when the short‐term interest rate is at the zero lower bound and develops new empirical estimates of the effects of the maturity structure of publicly held debt on the term structure of interest rates. We use a model of risk‐averse arbitrageurs to develop measures of how the maturity structure of debt held by the public might affect the pricing of level, slope, and curvature term structure risk. We find that these Treasury factors historically were quite helpful for predicting both yields and excess returns over 1990–2007. The historical correlations are consistent with the claim that if in December 2006, the Fed were to have sold off all its Treasury holdings of less than 1‐year maturity (about $400 billion) and use the proceeds to retire Treasury debt from the long end, this might have resulted in a 14‐basis‐point drop in the 10‐year rate and an 11‐basis‐point increase in the 6‐month rate. We also develop a description of how the dynamic behavior of the term structure of interest rates changed after hitting the zero lower bound in 2009. Our estimates imply that at the zero lower bound, such a maturity swap would have the same effects as buying $400 billion in long‐term maturities outright with newly created reserves and could reduce the 10‐year rate by 13 basis points without raising short‐term yields.

Sharing Longevity Risk: Why Governments Should Issue Longevity Bonds

Government-issued longevity bonds would allow longevity risk to be shared efficiently and fairly between generations. In exchange for paying a longevity risk premium, the current generation of retirees can look to future generations to hedge their aggregate longevity risk. There are also wider social benefits. Longevity bonds will lead to a more secure pension savings market - both defined contribution and defined benefit - together with a more efficient annuity market resulting in less means-tested benefits and a higher tax take. The emerging capital market in longevity-linked instruments can get help to kick start market participation through the establishment of reliable longevity indices and key price points on the longevity risk term structure and can build on this term structure with liquid longevity derivatives.An earlier version was presented at ‘Risk Sharing in Defined Contribution Pension Schemes’, Department for Work and Pensions and Netspar Conference, University of Exeter, 7-8 January 2010

What risks do corporate bond put features insure against?

Corporate bond prices are known to be influenced by default and term structure risk in addition to non‐default risks such as illiquidity. Putable corporate bonds allow investors to sell their holdings back to the issuer and may thus provide insurance against all of these risks. We first document empirically that embedded put option values are related to proxies for all three. In a second step, we develop a valuation model that simultaneously captures default and interest rate risk. We use this model to disentangle the reduction in yield spread enjoyed by putable bonds that can be attributed to each risk. Perhaps surprisingly, the most important reduction is due to mitigated default or spread risk, followed by term structure risk. The reduction in the non‐default component is present but rather small.

Predicting Returns with a Co-Fractional VAR Model

We use co-fractional models to evaluate the predictive relations between returns and a valuation ratio. The co-fractional model can handle situations where financial returns are predicted using persistent valuation ratios, like dividend to price. For our application we consider very long time series, covering 355 years of real-estate returns and rent to price ratios. We find robust evidence of a fractional root of d=0.75 in the rent to price ratio. The co-fractional model empirically outperforms the traditional triangular time-series model of return predictability. For annual data, the difference in predictive R-squared is about 8%. We conclude that the co-fractional VAR provides an alternative parsimonious model for the interaction between returns and valuation ratios. The long-memory properties of the fractional model have important implications for the fi t of present-value models and the term structure of risk.

Glide path and dynamic asset allocation of target date funds

The glide path of typical target date funds is based on the relatively simple assumption of risk. If an explicit term structure of risk is present or risk is time-varying, the conventional glide path may not be adequate to fulfil the purpose of target date funds. We introduce a new approach to define the glide path of target date funds. Our starting point is to determine the level of risk budget for each target date. According to the pre-defined risk budget, we derive the asset allocation of target date funds by explicitly incorporating the current term structure of risk. Because risk does change through different market phases, we implement a dynamic asset allocation strategy for target date funds which considers simultaneously both the pre-defined risk budget and the prevailing market risks. The main difference is that at any given time our risk-controlled dynamically-rebalanced target date funds would not exceed the pre-defined risk budget regardless of market movements.