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Abstract:
In this paper, we propose a general method for pricing and hedging non-standard American options. The proposed method applies to any kind of American-style contract for which the payoff function has a Markovian representation in the state space. Specifically, we obtain an analytic solution for the value and hedge parameters of path-dependent American options such as barrier options. The solution includes standard American options as a special case. The analytic formula also allows us to identify and exploit two key properties of the optimal exercise boundary - homogeneity in price parameters and time-invariance - for American options. In addition, some new put-call "symmetry" relations are also derived. These properties suggest a new, efficient and integrated approach to pricing and hedging a variety of standard and non-standard American options. From an implementation perspective, this approach avoids the current practice of repetitive computation of option prices and hedge ratios. Our implementation of the analytic formula for barrier options indicates that the proposed approach is both efficient and accurate in computing option values and option hedge parameters. In some cases, our method is faster by about four orders of magnitude than existing numerical methods with equal accuracy. In particular, the method overcomes the difficulty that existing numerical methods have in dealing with prices close to the barrier, the case where the barrier matters most.

Abstract:
We derive general properties of two-factor models of the term structure of interest rates and, in particular, the process for futures prices and rates. Then, as a special case, we derive a no-arbitrage model of the term structure in which any two futures rates act as factors. The term structure shifts and tilts as the factor rates vary. The cross-sectional properties of the model derive from the solution of a two dimensional autoregressive process for the short-term rate, which exhibits both mean reversion and a lagged persistence parameter. We show that the correlation of the futures rates is restricted by the no-arbitrage conditions of the model. In addition, we investigate the determinants of the volatility of the futures rates of various maturities. These are shown to be related to the volatilities of the short rate, the volatility of the second factor, the degree of mean reversion and the persistence of the second factor shock. We obtain specific results for futures rates in the case where the logarithm of the short-term rate [e.g., the London Inter-Bank Offer Rate (Libor)] follows a two-dimensional process. Our results lead to empirical hypotheses that are testable using data from the liquid market for Eurocurrency interest rate futures contracts.

Abstract:
We derive general properties of two-factor models of the term structure of interestrates and, in particular, the process for futures prices and rates. Then, as a special case, we derive a no-arbitrage model of the term structure in which any two futures rates act as factors. In this model, the term structure shifts and tilts as the factor rates vary. The cross-sectional propertiesof the model derive from the solution of a two-dimensional, autoregressive process for the short-term rate, which exhibits both mean-reversion and a lagged persistence parameter. We show that the correlation of the futures rates is restricted by the no-arbitrage conditions of the model. In addition, we investigate the determinants of the volatilities and the correlations ofthe futures rates of various maturities. These are shown to be related to the volatility of the short rate, the volatility of the second factor, the degree of mean-reversion and the persistence of the second factor shock. We also discuss the extension of our model to three or more factors. We obtain specific results for futures rates in the case where the logarithm of the short-term rate [e.g., the London Inter-Bank Offer Rate (LIBOR)] follows atwo-dimensional process. We calibrate the model using data from Eurocurrencyinterest rate futures contracts, using alternative optimization criteria. We then derive the term structures of volatilities and correlations implied by the model.

Abstract:
We derive general properties of two-factor models of the term structure of interest rates and, in particular, the process for futures prices and rates. Then, as a special case, we derive a no-arbitrage model of the term structure in which any two futures rates act as factors. In this model, the term structure shifts and tilts as the factor rates vary. The cross-sectional properties of the model derive from the solution of a two-dimensional, autoregressive process for the short-term rate, which exhibits both mean-reversion and a lagged persistence parameter. We show that the correlation of the futures rates is restricted by the no-arbitrage conditions of the model. In addition, we investigate the determinants of the volatilities and the correlations of the futures rates of various maturities. These are shown to be related to the volatility of the short rate, the volatility of the second factor, the degree of mean-reversion and the persistence of the second factor shock. We also discuss the extension of our model to three or more factors. We obtain specific results for futures rates in the case where the logarithm of the short-term rate [e.g., the London Inter-Bank Offer Rate LIBOR follows a two-dimensional process. Our results lead to empirical hypotheses that are testable using data from the liquid market for Eurocurrency interest rate futures contracts.

Abstract:
This paper examines the pricing and hedging performance of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus,the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.

Interest rate options, interest rate caps/floors, term structure of interest rates, hedging

Abstract:
We present a cash-flow based model of corporate debt valuation that incorporates two novel features. First, we allow for the separation and optimal determination of the firm's debt-service and dividend policies; in particular, the firm is allowed to maintain cash reserves to meet future debt obligations. Second, our model admits the possibility that raising resources through issuance of new equity could be a costly procedure. In contrast, much of the previous literature has considered only dividend polices that are the "residual" consequences of debt-service policy, and has assumed new equity issuance costs are either zero or infinite. We provide an analytical characterization of equilibrium behavior in our model. Numerical analysis of the equilibrium reveals that our model predicts substantially higher yield spread than the canonical Merton-type model. More importantly, we find that the two novel features of our model are crucial determinants of not only the overall spread that result but also of the marginal impact of allowing for debt-service to be strategic. Specifically: (a) assuming residual rather than optimal dividend policies can result in a significant upward bias in the yield spread predicted by the model; (b) the size of this bias depends in a central way on the costs of equity issuance; (c) the marginal impact of strategic debt-service is substantial, in general, only for low equity-issuance costs, and (d) under optimally-determined dividends, strategic debt-service can actually result in a narrowing of yield spreads. In summary, our results indicate that endogenizing dividend policy and allowing for equity-issuance costs can enhance the model's content substantially, while ignoring these factors could introduce non-trivial biases into the valuation.

Abstract:
We present a cash flows based model of corporate debt valuation that incorporates two novel features. First, we allow for the separation and optimal determination of the firm's debt-service and dividend policies; in particular, the rm is allowed to maintain cash reserves to meet future debt obligations.Second, our model admits the possibility that raising resources through issuance of new equity could be a costly procedure. In contrast, much of the previous literature has considered only dividend policies that are the \residual" consequences of debt-service policy, and has assumed new equity issuance costs are either zero or infinite.We provide an analytical characterization of equilibrium behavior in our model. Numericalanalysis of the equilibrium reveals that our model predicts substantially higher yield spreads than the canonical Merton-type model. More importantly, we find that the two novel features of our model are crucial determinants of not only the overall spreads that result but also of the marginalimpact of allowing for debt-service to be strategic. Specifically: (a) assuming residual rather than optimal dividend policies can result in a significant upward bias in the yield spreads predicted bythe model; (b) the size of this bias depends in a central way on the costs of equity issuance; (c) the marginal impact of strategic debt-service is substantial, in general, only for low equity-issuancecosts, and (d) under optimally-determined dividends, strategic debt-service can actually result in a narrowing of yield spreads. In summary, our results indicate that endogenizing dividend policy and allowing for equity-issuance costs can enhance the model's content substantially, while ignoring these factors could introduce non-trivial biases into the valuation.

Abstract:
We present a cash-flow based model of corporate debt valuation that incorporates two novel features. First, we allow for the separation and optimal determination of the firm's debt-service and dividend policies; in particular, the firm is allowed to maintain cash reserves to meet future debt obligations. Second, our model admits the possibility that raising resources through issuance of new equity could be a costly procedure. In contrast, much of the previous literature has considered only dividend policies that are the residual consequences of debt-service policy, and has assumed new equity issuance costs are either zero or infinite.

We provide an analytical characterization of equilibrium behavior in our model. Numerical analysis of the equilibrium reveals that our model predicts substantially higher yield spreads than the canonical Merton-type model. More importantly, we find that the two novel features of our model are crucial determinants of not only the overall spreads that result but also of the marginal impact of allowing for debt-service to be strategic. Specifically: (a) assuming residual rather than optimal dividend policies can result in a significant upward bias in the yield spreads predicted by the model; (b) the size of this bias depends in a central way on the costs of equity issuance; (c) the marginal impact of strategic debt-service is substantial, in general, only for low equity-issuance costs, and (d) under optimally-determined dividends, strategic debt-service can actually result in a narrowing of yield spreads. In summary, our results indicate that endogenizing dividend policy and allowing for equity-issuance costs can enhance the model's content substantially, while ignoring these factors could introduce non-trivial biases into the valuation.

Abstract:
We build a multi-factor, no-arbitrage model of the term structure of spot interest rates. The stochastic factors are the short-term interest rate and the premia of the futures rates over the short-term interest rates. In the three-factor version of the model, for example, the first factor is the three-month LIBOR, the second factor is the premium of the first futures LIBOR over spot LIBOR, and the third factor is the incremental premium of the second futures over the first. The model provides an extension of the lognormal interest rate model of Black and Karasinski (1991) to multiple factors, each of which can exhibit mean-reversion.This method is computationally efficient for several reasons. First, we suggest calibrating the model to LIBOR futures prices, which enables us to satisfy the no-arbitrage condition without resorting to iterative methods. Second, we modify and implement the binomial approximation methodology of Nelson and Ramaswamy (1990) and Ho, Stapleton and Subrahmanyam (1995) to compute a multi-period tree of rates with the no-arbitrage property. The method uses a recombining two or three-dimensional binomial lattice of interest rates that minimizes the number of states and term structures over time. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of futures rates as well as the term structure of volatilities implied by the prices of interest rate caps and floors. We use the model to price European-style and Bermuda-style swaptions and yield-spread options.To implement the methodology, we first calibrate the model to the caplet implied-volatility curve on a given day, and then use the model to price European-style swaptions. We find that the two-factor model, where the LIBOR mean reverts rapidly to a slowly mean-reverting second factor, overprices the swaptions relative to market quotations. However, introducing a third factor significantly reduces the overpricing. The calibrated model is used to price Bermudan-style swaptions and yield-spread options. Then, we re-calibrated the two-factor model simultaneously to caplet and swaption prices and use the model output to price Bermudan-style swaptions.

Abstract:
We build a multi-factor model of the term structure of spot interest rates. The stochastic factors are the short-term interest rate and the premia of the future rates over the short-term interest rate. In the three-factor version of the model, for example, the first-factor is the three month LIBOR the second factor is the premium of the first futures LIBOR over spot lIBOR, and the third factor is the incremental premium of the second futures aver the first, The model provides and extension of the longnormal interest rate model of Black and Karasinuski (1991) to multiple factors. each of which can exhibit mean-reversion.

Abstract:
We build a multi-factor, no-arbitrage model of the term structure of interest rates. The stochastic factors are the short-term interest rate and the premia of the futures rates over the short-term interest rate. In the three-factor version of the model, for example, the first factor is the three-month LIBOR, the second factor is the premium of the first futures LIBOR over spot LIBOR, and the third factor is the incremental premium of the second futures over the first. The model provides an extension of the lognormal interest rate model of Black and Karasinski (1991) to multiple factors, each of which can exhibit mean-reversion. The method is computationally efficient for several reasons. First, since our model is based on LIBOR futures prices, we can satisfy the no-arbitrage condition without resorting to iterative methods. Second, we modify and implement the binomial approximation methodology of Nelson and Ramaswamy (1990) and Ho, Stapleton and Subrahmanyam (1995) to compute a multi-period tree of rates with the no-arbitrage property.

The method uses a recombining two or three-dimensional binomial lattice of interest rates that minimizes the number of states and term structures over time. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of futures rates as well as the term structure of volatilities implied by the prices of interest rate caps and floors. We use the model to price European-style, Bermudan-style, and American-style swaptions.

To implement the methodology, we first calibrate the model to the caplet implied-volatility curve on a given day, and then use the model to price European-style swaptions. We find that the two-factor model, where the LIBOR mean reverts rapidly to a slowly mean-reverting second factor overprices the swaptions relative to market quotations. However, introducing a third factor significantly reduces the overpricing. Finally, we re-calibrate the two-factor model simultaneously to caplet and swaption prices and use the model output to price Bermudan-style swaptions.

Abstract:
Can the liquidity premium in asset prices, as documented in the exchange-traded equity and bond markets, be generalized to the over-the-counter (OTC) derivative markets? Using OTC euro (€) interest rate cap and floor data, we find that illiquid options trade at higher prices relative to liquid options. This liquidity discount, though opposite to that found in equities and bonds, is consistent with the structure of this OTC market and the nature of its demand and supply forces. Our results suggest that the effect of liquidity on asset prices cannot be generalized without regard to the characteristics of the market.

Liquidity, interest rate options, euro interest rate markets, Euribor market, OTC options markets

Abstract:
The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets' returns. For that purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, "excessive" volatility and comovement play an important role in return dynamics as well. Further, our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. However, we also show that stock and bond returns tend to react to the expected component of these announcements. This evidence casts some doubts on the efficiency of the U.S. financial markets with respect to widely anticipated and tracked releases of macroeconomic data. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.

Abstract:
The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets' returns. Forthat purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, "excessive" volatility and comovement play an important role in return dynamics as well. Further, our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. However, we also show that stock and bond returns tend to react to the expected component of these announcements. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.

Volatility, Comovement, Information, Market Efficiency

Abstract:
The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets' returns. For that purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, excessive volatility and comovement play an important role in return dynamics as well. Further, our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. However, we also show that stock and bond returns tend to react to the expected component of these announcements. This evidence casts some doubts on the efficiency of the U.S. financial markets with respect to widely anticipated and tracked releases of macroeconomic data. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.

Volatility, comovement, information, market efficiency

Abstract:
In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990-96. We obtain measures of the spreads of the swap rates over comparable Japanese Government Bonds (JGBs) for different maturities and analyze the relationship between the swap spreads and credit risk variables. Our empirical results in the yen swap market indicate that: 1) the commonly-used assumption of lognormal default-free interest rates and swap spreads is strongly rejected by the data, 2) the term structure of swap spreads displays a humped-shape, and 3) the shocks in the yen swap spread are negatively correlated with the shocks in the comparable default-free spot rates, especially for longer maturities. Our analysis also indicates that yen swap spreads behaved very differently from the credit spreads on Japanese corporate bonds in the early nineties. In contrast to Japanese corporate bonds, we find that the yen swap spread is also significantly related to proxies for the long-term credit risk factor. Furthermore, the swap spread is negatively related to the level and slope of the term structure and positively related to the curvature, indicating that the credit "optionality" is priced in the swap rate. Thus, overall, the yen swap market was sensitive to credit risk during the period of our study.

Credit Risk, Japanese Government Bonds Market, Swap Pricing

Abstract:
In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990-96. We obtain measures of the spreads of the swap rates over comparable Japanese Government Bonds (JGBs) for different maturities and analyze the relationship between the swap spreads and credit risk variables.Our empirical results in the yen swap market indicate that: 1) the commonly-used assumption of lognormal default-free interest rates and swap spreads is strongly rejected by the data, 2) the term structure of swap spreads displays a humped-shape, and 3) the shocks in the yen swap spread are negatively correlated with the shocks in the comparable default-free spot rates, especially for longer maturities.Our analysis also indicates that yen swap spreads behaved very differently from the credit spreads on Japanese corporate bonds in the early nineties. In contrast to Japanese corporate bonds, we find that the yen swap spread is also significantly related to proxies for the long-term credit risk factor. Furthermore, the swap spread is negatively related to the level and slope of the term structure and positively related to the curvature, indicating that the credit "optionality" is priced in the swap rate. Thus, overall, the yen swap market was sensitive to credit risk during the period of our study.

Credit Risk, Japenese Goverment Bonds Market, Swap Pricing

Abstract:
In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990-96. We obtain measures of the spreads of the swap rates over comparable Japanese Government Bonds (JGBs) for different maturities and analyze the relationship between the swap spreads and credit risk variables. Our empirical results in the yen swap market indicate that: 1) the commonly-used assumption of lognormal default-free interest rates and swap spreads is strongly rejected by the data, 2) the term structure of swap spreads displays a humped-shape, and 3) the shocks in the yen swap spread are negatively correlated with the shocks in the comparable default-free spot rates, especially for longer maturities. Our analysis also indicates that yen swap spreads behaved very differently from the credit spreads on Japanese corporate bonds in the early nineties. In contrast to Japanese corporate bonds, we find that the yen swap spread is also significantly related to proxies for the longterm credit risk factor. Furthermore, the swap spread is negatively related to the level and slope of the term structure and positively related to the curvature, indicating that the credit optionality is priced in the swap rate. Thus, overall, the yen swap market was sensitive to credit risk during the period of our study.

Credit Risk, Japanase Government Bonds market, Swap Pricing

Abstract:
In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990-96. We obtain measures of the spreads of the swap rates over comparable Japanese Government Bonds (JGBs) for different maturities and analyze the relationship between the swap spreads and credit risk variables.

Our empirical results in the yen swap market indicate that: 1) the commonly-used assumption of lognormal default-free interest rates and swap spreads is strongly rejected by the data, 2) the term structure of swap spreads displays a humped-shape, and 3) the shocks in the yen swap spread are negatively correlated with the shocks in the comparable default-free spot rates, especially for longer maturities.

Our analysis also indicates that yen swap spreads behaved very differently from the credit spreads on Japanese corporate bonds in the early nineties. In contrast to Japanese corporate bonds, we find that the yen swap spread is also significantly related to proxies for the long-term credit risk factor. Furthermore, the swap spread is negatively related to the level and slope of the term structure and positively related to the curvature, indicating that the credit 'optionality' is priced in the swap rate. Thus, overall, the yen swap market was sensitive to credit risk during the period of our study.

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock margins and options margins (relative to stock margins) are sufficiently large or small but not when they are of moderate size.

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock'sbid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size.

Abstract:
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size.

Abstract:
In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that, in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations from expected market valuations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.

Abstract:
In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.

liquidity, corporate bonds, market microstructure, OTC markets

Abstract:
We build a no-arbitrage model of the term structure of interest rates using two stochastic factors, the short-term interest rate and the premium of the futures rate over the short-term interest rate. The model provides an extension of the lognormal interest rate model of Black and Karasinski (1991) to two factors, both of which can exhibit mean-reversion. The method is computationally efficient for several reasons. First, the model is based on futures prices, enabling us to satisfy the no-arbitrage condition without resorting to iterative methods. Second, we modify and implement the binomial approximation methodology of Nelson and Ramaswamy (1990) and Ho, Stapleton and Subrahmanyam (1995) to compute a multiperiod tree of rates with the no-arbitrage property. The method uses a recombining two-dimensional binomial lattice of interest rates that minimizes the number of states and term structures over time. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of futures rates as well as the term structure of volatilities implied by the prices of interest rate caps and floors. We use the model to price European-style, Bermudan-style, and American-style swaptions. These prices are shown to be highly sensitive to the existence of the second factor and its volatility characteristics.

Abstract:
In an incomplete market economy, all claims cannot be priced uniquely based on arbitrage. The prices of attainable claims (those that are spanned by traded claims) can be determined uniquely, whereas the prices of those that are unattainable can only be bounded. We first show that tighter price bounds can be determined by considering all possible portfolios of unattainable claims for which there are bid/offer prices. We provide an algorithm to establish these bounds. We then examine how a price-taking agent can "package" new assets in order to take advantage of the incompleteness since the market places a premium on claims that improve its spanning. In particular, we prove that a firm with a new investment opportunity can maximize its value by "stripping away" the maximal attainable portion of the cash flow, for which prices are determined uniquely, and selling the balance to investors at prices that preclude arbitrage. Our framework has several applications in financial economics to problems ranging from securitization to the valuation of real options.

Abstract:
In an incomplete market economy, all claims cannot be priced uniquely based on arbitrage. The prices of attainable claims (those that are spanned by traded claims) can be determined uniquely, whereas the prices of those that are unattainable can only be bounded. We first show that tighter price bounds can be determined by considering all possible portfolios of unattainable claims for which there are bid/offer prices. We provide an algorithm to establish these bounds. We then examine how a price-taking agent can "package" new assets in order to take advantage of the incompleteness since the market places a premium on claims that improve its spanning. In particular, we prove that a firm with a new investment opportunity can maximize its value by "stripping away" the maximal attainable portion of the cash flow, for which prices are determined uniquely, and selling the balance to investors at prices that preclude arbitrage. Our framework has several applications in financial economics to problems ranging from securitization to the valuation of real options.

Incomplete Markets, Valuation and Spanning, Securitization

Abstract:
This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models of the spot and the forward interest rates on the basis of their out-of-sample predictive ability in terms of pricing and hedging performance. The one-factor models analyzed consist of two spot-rate specifications (Hull and White (1990) and Black-Karasinski (1991), five forward rate specifications (within the general Heath, Jarrow and Morton (1990b) class), and one LIBOR market model (Brace, Gatarek and Musiela (1997) [BGM]). For two-factor models, two alternative forward rate specifications are implemented within the HJM framework. We conduct tests on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Overall, the one-factor lognormal model for short term interest rates outperforms other competing models in pricing tests, while two-factor models perform significantly better than one-factor models in hedging tests. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus, the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.

Interest rate options, interest rate caps/floors, term structure of interest rates

Abstract:
An Examination of the Static and Dynamic Performance of Interest Rate Option Pricing Models In the Dollar Cap-Floor Markets Anurag Gupta Marti G. Subrahmanyam Abstract This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models of the spot and the forward interest rates on the basis of their out-of-sample predictive ability in terms of pricing and hedging performance. In addition, the models are evaluated based on the stability of their parameters, the presence of systematic biases, and their numerical complexity and computational efficiency. We conduct tests on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Overall, the one-factor lognormal model for short term interest rates outperforms other competing models in pricing tests, while two-factor models perform significantly better than one-factor models in hedging tests. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus, the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.

Abstract:
In this paper, we investigate Japanese yen and U.S. dollar interest rate swap markets during the period 1990-99. We measure the spreads of the swap rates over comparable treasury yields (on Japanese Government Bonds (JGBs) and U.S. Treasury bonds, respectively) for different maturities. We then analyze the relationship between the swap spreads in the two markets.

Our main empirical results are that: (1) the correlations between yen and dollar interest swap spreads are low, indicating that the credit risk factor is country-specific, rather than global in nature, (2) dollar interest rate swaps "Granger-cause" the changes in the spreads of yen interest rate swaps for the long (ten-year) maturities, but the causality does not run the other way, and (3) yen swap spreads are highly correlated with the interest rate differentials between the two markets, and the interest rate differentials have a significant impact on subsequent movements in the yen swap spreads. These empirical results indicate that the specific institutional aspects of the yen fixed income market, such as illiquidity and market frictions, may have affected the yen interest swap rate and the swap spread.

interest rate swaps, interest rate swap spreads, relative value, international linkages, credit risk

Abstract:
This paper investigates the liquidity effect in asset pricing by studying the liquidity-premium relationship of an American Depositary Receipt (ADR) and its underlying share. Using the Amihud (2002) measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity and lower home share liquidity, in terms of changes in these variables. We find that the liquidity effects remain strong after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the stock market performance, as well as several variables measuring the openness and transparency of the home market.

American Depositary Receipts (ADRs), dual listing, liquidity, turnover, premium

Abstract:
Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their riskless benchmarks. One candidate for the unexplained portion of the spread is a premium for the illiquidity in the corporate bond market. We investigate this issue byrelating the liquidity of corporate bonds, as measured by their ease of market access, to the non-default component of their respective corporate bond yields using the portfolio holdings database of the largest custodian in the market. The ease of access of a bond is measured using a recently developed measurecalled latent liquidity that weights the turnover of funds holding the bond by their fractional holdings of the bond. We use the credit default swap (CDS) prices of the bond issuer to control for the credit risk of a bond. At an aggregate level, we find a contemporaneous relationship between aggregate latent liquidity and the average non-default component in corporate bond yields. Additionally, for individualbonds, we find that bonds with higher latent liquidity have a lower non-default component of their yield spread. We also document that bonds that are held by funds that exhibit greater buying activity command lower spreads (i.e., are more expensive), while the opposite is true for those that exhibitgreater selling activity. We also find that the liquidity in the CDS market has an impact on bond pricing, over and above bond-specific liquidity effects.

Abstract:
Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their riskless benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds, as measured by their ease of market access, to the basis between the credit default swap (CDS) price of the issuer and the par-equivalent corporate bond yield spread. The ease of access of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk negatively affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond. Furthermore, we find that when default risk of a firm is high, its illiquid bonds are more expensive. We also document that bond-level variables related to features of the contract that may be related to credit risk, such as the presence of covenants, have a negative impact on the CDS-bond basis. These findings are consistent with limits to arbitrage between the CDS and bond markets, due to the costs of "shorting" bonds.

Corporate Bonds, Credit Risk, Credit Default Swaps, Basis, Liquidity, Latent Liquidity

Abstract:
We investigate the Japanese yen and U.S. dollar interest rate swap markets during the period 1990-2000, by examining the spreads of the swap rates over comparable treasury yields (on Japanese Government Bonds (JGBs) and U.S. Treasury bonds, respectively) for different maturities. We then analyze the transmission of shocks in the swap spreads and their volatilities from one market to the other.

Our main findings are: (1) the correlations between the yen and dollar interest swap spreads are low, indicating that the credit risk factor is country-specific, rather than global in nature, (2) the changes in the dollar interest rate swap spreads "Granger-cause" the changes in the spreads of yen interest rate swaps for the long (10-year) maturities, but the causality does not run the other way, (3) yen swap spreads are highly correlated with the interest rate differentials between the two markets, and the interest rate differentials have a significant impact on subsequent movements in the yen swap spreads, (4) the transmission of the volatility of swap spreads is strong from the dollar to the yen markets and relatively weak in the other direction, and (5) shocks to the dollar swap spread have an asymmetric impact on the volatilities of the spreads in both the yen and dollar swap markets, i.e., an increase in the dollar swap spread leads to higher future volatility of the spreads in both swap markets, but a decrease does not. These empirical results suggest that specific institutional aspects, such as illiquidity and market frictions, may have affected the yen interest swap market more than its dollar counterpart.

Interest Rate Swaps, Interest Rate Swap Spreads, Volatility of Swap Spreads, Credit Risk, Transmission of Swap Spreads

Abstract:
In many markets, the term structure of interest rates implied by coupon Treasury bonds provides a key input for pricing and hedging interest rate-sensitive securities. Previous studies in the Japanese market, however, suggest that the prices of the Japanese Government Bonds (JGB's) were significantly affected modelling in the Japanese context bases on interest rate factors could leave to misleading results. Since the previous studies, there have been significant structural changes in the regulatory environment, and in the liquidity of the Japanese bond market in the 1990's. In this light, we examine the effect of these changes on the JGB prices during the period between 1990 and 1996, by analyzing the term structure of interest rates in the JGB market over time. Specifically, we use the B-spline method to fit the term structure of interest rates using weekly prices of "non-benchmark" ten-year JGB's. We also use a non-linear econometric model to examine the significance of the "coupon" effects, which are the results of regulatory, accounting and liquidity factors.

Japanese Government Bond Market, Accounting and Tax Effects, Term Structure

Abstract:
In many markets, the term structure of interest rates implied by coupon Treasury bonds provides a key input for pricing and hedging interest rate-sensitive securities. Previous studies in the Japanese market, however, suggest that the prices of the Japanese Government Bonds (JGB's) were significantly affected by regulatory and liquidity factors. Consequently, it has been argued that term structure modelling in the Japanese context based on interest rate factors could lead to misleading results. Since the previous studies, there have been significant structural changes in the regulatory environment, and in the liquidity of the Japanese bond market in the 1990's. In this light, we examine the effect of these changes on the JGB prices during the period between 1990 and 1996 by analyzing the term structure of interest rates in the JGB market over time. Specifically, we use the B-spline method to fit the term structure of interest rates using weekly prices of "non benchmark" ten-year JGB's. We also use a non-linear econometric model to examine the significance of the "coupon" effects, which are the results of regulatory, accounting and liquidity factors.

Our empirical analysis shows that it is possible to closely fit the term structure of interest rates in the JGB market, with fitted price errors only slightly larger than those found in similar studies of the U.S. Treasury bond market. Furthermore, the fitted price errors diminish over our sample period, suggesting that the effect of non-present value factors became somewhat muted over time. Our empirical results also indicate that the coupon of a bond in the JGB market has a highly nonlinear effect on the prices due to the "par-bond" effect and the "high-coupon" effect, although the "par-bond" effect is more pronounced in the recent period. Further analysis shows that three factors (level, slope and curvature) explain a substantial proportion of the variation in the JGB spot rates, as in the case of the U.S. Treasury market. Overall, these results indicate that the efficiency of the JGB markets has improved over time. Hence, the time-series movement of the JGB's can be captured to a substantial degree by common interest rate factors, although care should be taken to incorporate the special characteristics of individual bonds.

Abstract:
In many markets, the term structure of interest rates implied by coupon Treasury bonds provides a key input for pricing and hedging interest rate-sensitive securities. Previous studies in the Japanese market, however, suggest that the prices of the Japanese Government Bonds (JGB's) were significantly affected by regulatory and liquidity factors. Consequently, it has been argued that term structure modelling in the Japanese context based on interest rate factors could lead to misleading results. Since the previous studies, there have been significant structural changes in the regulatory environment, and in the liquidity of the Japanese bond market in the 1990's. In this light, we examine the effect of these changes on the JGB prices during the period between 1990 and 1996 by analyzing the term structure of interest rates in the JGB market over time. Specifically, we use the B-spline method to fit the term structure of interest rates using weekly prices of "non-benchmark" ten-year JGB's. We also use a non-linear econometric model to examine the significance of the "coupon" effects, which are the results of regulatory, accounting and liquidity factors.

Our empirical analysis shows that it is possible to closely fit the term structure of interest rates in the JGB market, with fitted price errors only slightly larger than those found in similar studies of the U.S. Treasury bond market. Furthermore, the fitted price errors diminish over our sample period, suggesting that the effect of non-present value factors became somewhat muted over time. Our empirical results also indicate that the coupon of a bond in the JGB market has a highly nonlinear effect on the prices due to the "par-bond" effect and the "high-coupon" effect, although the "par-bond" effect is more pronounced in the recent period. Further analysis shows that three factors (level, slope and curvature) explain a substantial proportion of the variation in the JGB spot rates, as in the case of the U.S. Treasury market. Overall, these results indicate that the efficiency of the JGB markets has improved over time. Hence, the time-series movement of the JGB's can be captured to a substantial degree by common interest rate factors, although care should be taken to incorporate the special characteristics of individual bonds.

Abstract:
We use a unique data-set to study liquidity effects in the US corporate bond market, covering more than 20,000 bonds. Our analysis explores time-series and cross-sectional aspects of corporate bond yield spreads, with the main focus being on the quantification of the impact of liquidity factors, while controlling for credit risk. Our time period starts in October 2004 when detailed transaction data from the Trade Reporting and Compliance Engine (TRACE) became available. In particular, we examine three different regimes during our sample period, the GM/Ford crisis in 2005 when a segment of the corporate bond market was affected, the sub-prime crisis since mid-2007, which was much more pervasive across the corporate bond market, and the period in between, when market conditions were more normal.

We employ a wide range of liquidity measures and find in our panel-regression analysis that liquidity effects account for approximately one-tenth of the explained market-wide corporate yield spread changes. During periods of crisis, the economic impact of the liquidity measures increases significantly. Our data-set allows us to examine in greater detail liquidity effects in various sub-segments of the market: investment grade vs. speculative grade bonds, financial sector firms which have been particularly affected by the crisis vs. industrial firms, and retail vs. institutional trades. In addition, our cross-sectional analysis based on Fama-MacBeth regressions shows that liquidity explains an important part of the variation in yield spreads across bonds, after accounting for credit risk. These results yield important insights regarding the liquidity drivers of corporate bond yield spreads, particularly during periods of crisis.

liquidity, corporate bonds, financial crises, OTC markets

Abstract:
We use a unique data-set to study liquidity effects in the US corporate bond market, covering more than 20,000 bonds. Our analysis explores time-series and cross-sectional aspects of corporate bond yield spreads, with the main focus being on the quantification of the impact of liquidity factors, while controlling for credit risk. Our time period starts in October 2004 when detailed transaction data from the Trade Reporting and Compliance Engine (TRACE) became available. In particular, we examine three different regimes during our sample period, the GM/Ford crisis in 2005 when a segment of the corporate bond market was affected, the sub-prime crisis since mid-2007, which was much more pervasive across the corporate bond market, and the period in between, when market conditions were more normal.

We employ a wide range of liquidity measures and find in our panel-regression analysis that liquidity effects account for approximately one-tenth of the explained market-wide corporate yield spread changes. During periods of crisis, the economic impact of the liquidity measures increases significantly. Our data-set allows us to examine in greater detail liquidity effects in various sub-segments of the market: investment grade vs. speculative grade bonds, financial sector firms which have been particularly affected by the crisis vs. industrial firms, and retail vs. institutional trades. In addition, our cross-sectional analysis based on Fama-MacBeth regressions shows that liquidity explains an important part of the variation in yield spreads across bonds, after accounting for credit risk. These results yield important insights regarding the liquidity drivers of corporate bond yield spreads, particularly during periods of crisis.

Liquidity, Corporate Bonds, Financial Crises, OTC Markets

Abstract:
We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (¬) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.

Abstract:
We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.

Volatility smiles, interest rate options, euro interest rate markets, Euribor market

Abstract:
Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton (1974)-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing.

We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.

Strategic debt-service, interaction of optionalities, liquidity default, strategic default, cash-management

Abstract:
Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton (1974)-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing.

We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.

strategic debt-service, interaction of optionalities, liquidity default, strategic default, cash-management

Abstract:
In this paper we study the determinants of business groups' ownership structure using unique panel data on Korean chaebols. In particular, we attempt to understand how pyramids form over time. We find that chaebols grow vertically (that is, pyramidally) as the family uses well-established group firms (central firms) to set up and acquire younger firms that have low profitability and high capital requirements. Chaebols grow horizontally (that is, using direct family ownership) when the family acquires firms that are highly profitable and require less capital. Our evidence suggests that the (previously documented) lower profitability of pyramidal firms is partly due to a selection effect (e.g., the family optimally places low profitability firms in pyramids). To show this, we examine instances of large changes in the ownership structure of group firms. Specifically, we find that poor past performance predicts an increase in the degree of pyramiding in a firm's ownership structure. Most compellingly, we find that the profitability of new group firms in the year before they are added to the group predicts whether they are added to pyramids or controlled directly by the family. We also examine the relative valuation of chaebol firms. We find that the group's central firms trade at a discount relative to other public group firms possibly due to the selection of low-profitability, high capital intensity firms into pyramids. Our results shed light on the process by which pyramids form, and provide new evidence on the performance and valuation of business group firms.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
In this paper we study the determinants of business groups' ownership structure using unique panel data on Korean chaebols. In particular, we attempt to understand how pyramids form over time. We find that chaebols grow vertically (that is, pyramidally) as the family uses well-established group firms ("central firms'') to set up and acquire younger firms that have low profitability and high capital requirements. Chaebols grow horizontally (that is, using direct family ownership) when the family acquires firms that are highly profitable and require less capital. Our evidence suggests that the (previously documented) lower profitability of pyramidal firms is partly due to a selection effect (e.g., the family optimally places low profitability firms in pyramids). To show this, we examine instances of large changes in the ownership structure of group firms. Specifically, we find that poor past performance predicts an increase in the degree of pyramiding in a firm's ownership structure. Most compellingly, we find that the profitability of new group firms in the year before they are added to the group predicts whether they are added to pyramids or controlled directly by the family. We also examine the relative valuation of chaebol firms. We find that the group's central firms trade at a discount relative to other public group firms possibly due to the selection of low-profitability, high capital intensity firms into pyramids. Our results shed light on the process by which pyramids form, and provide new evidence on the performance and valuation of business group firms.

Business groups, family firms, firm performance, pyramids, cross-shareholdings, parent company discount

Abstract:
This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. Alternative one-factor and two-factor term structure models of the spot and the forward rate are evaluated on the basis of their out-of-sample predictive ability in terms of pricing and hedging performance. In addition, the models are evaluated based on the stability of their parameters, the presence of systematic biases, and their numerical complexity and computational efficiency. The tests are conducted on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlyingdistribution. Overall, the one-factor lognormal model for short term interest ratesoutperforms other competing models in pricing tests, while two-factor models perform significantly better than one-factor models in hedging tests. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus, the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges.This constitutes evidence against claims in the literature that correctly specifiedand calibrated one-factor models could replace multi-factor models for consistentpricing and hedging of interest rate contingent claims.

Interest rate options, interest rate caps/floors, term structure of interest rates

Abstract:
This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models of the spot and the forward interest rates on the basis of their out-of-sample predictive ability in terms of pricing and hedging performance. The one-factor models analyzed consist of two spot-rate specifications (Hull and White (1990) and Black-Karasinski (1991), five forward rate specifications (within the general Heath, Jarrow and Morton (1990b) class), and one LIBOR market model (Brace, Gatarek and Musiela (1997) [BGM]). For two-factor models, two alternative forward rate specifications are implemented within the HJM framework. We conduct tests on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Overall, the one factor lognormal model for short term interest rates outperforms other competing models in pricing tests, while two-factor models perform significantly better than one-factor models in hedging tests. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus, the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economicenvironment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.

Interest rate options, interest rate caps/floors, term structure of interest rates

Abstract:
Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their risk-less benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds to the basis between the credit default swap (CDS) price of the issuer and the parequivalent corporate bond yield spread. The liquidity of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. However highly illiquid bonds with high default risk are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of "shorting" illiquid bonds. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond.

Abstract:
We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of firms, investors, and an intermediary. The firms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the financial market, and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors. We derive necessary and sufficient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments, synergies among them, and their financing mechanisms. We illustrate these implications using an example of inventory decisions under random demand.

Abstract:
We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of firms, investors, and an intermediary. The firms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the financial market, and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors.

We derive necessary and sufficient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments, synergies among them, and their financing mechanisms.

Abstract:
Liquidity is generally viewed as a positive characteristic of a traded asset in positive net supply. Ceteris paribus, the higher liquidity of a given asset should be reflected in a higher price or a lower required return. This issue is of particular interest if the same asset is traded in multiple markets. In this setting, apart from the effect of liquidity on pricing in each market, there is the additional question of transmission of these liquidity effects across markets. This paper investigates the liquidity effect in asset pricing by studying the liquidity-premium relationship of an American Depositary Receipt (ADR) and its underlying share in the home market. Using the Amihud (2002) measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity, lower home share liquidity. We measure these effects, in terms of both the levels and changes, in both the premium and the liquidity variables. We find that the liquidity effects remain strong even after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the home country and the US stock market performance, as well as several variables measuring the openness and transparency of the home market.

American Depositary Receipts (ADRs), dual listing, liquidity, turnover

Abstract:
This paper examines the convexity bias introduced by pricing interest rate swaps off the Eurocurrency futures curve and the incorporation of this bias in prices over time. The convexity bias arises because of the difference between a futures versus a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swaps markets - $, ',', and DM - and implied rates cannot be explained by default risk differences, term structure effects, liquidity differences or information asymmetries between the swaps and the futures markets. Using a calibrated term structure model, the theoretical value of the convexity bias is found to be comparable to the empirically observed spread. This is evidence of mispricing of swap rates during the earlier years of the study, with a gradual elimination of that mispricing by incorporation of a convexity adjustment in swap pricing over time.

Abstract:
This paper examines the convexity bias introduced by pricing interest rate swaps offthe Eurocurrency futures curve and the market's adjustment of this bias in prices over time. The convexity bias arises because of the difference between a futures contractand a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swap markets - $, £, DM and ¥. The evidence suggests thatswaps were being priced off the futures curve (i.e. by ignoring the convexity adjustment) during the earlier years of the study, after which the market swap rates drifted below the rates implied by futures prices. The empirical analysis shows that this spread between the market and futures-implied swap rates cannot be explained by default risk differences, liquidity differences or information asymmetries between theswap and the futures markets. Using alternative term structure models (one-factorVasicek, Cox-Ingersoll and Ross, Hull and White, Black and Karasinski, and the two factor Heath, Jarrow and Morton), the theoretical value of the convexity bias is found to be related to the empirically observed swap-futures differential. We interpret these results as evidence of mispricing of swap contracts during the earlier years of the study, with a gradual elimination of that mis pricing by incorporation of a convexity adjustment in swap pricing over time.

Abstract:
This paper examines the convexity bias introduced by pricing interest rate swaps off the Eurocurrency futures curve and the market's adjustment of this bias in prices over time. The
convexity bias arises because of the difference between a futures versus a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swap markets - $, u, DM and ?. The evidence suggests that swaps were being priced off the futures curve (i.e. by ignoring the convexity adjustment) during the earlier years of the study, after which the market swap rates drifted below the rates implied by futures prices. The empirical analysis shows that this spread between the market and futures-implied swap rates cannot be explained by default risk differences, term structure effects, liquidity differences or information asymmetries between the swap and the futures markets. Using alternative term structure models (Vasicek, Cox-Ingersoll and Ross, Hull and White, and Black and Karasinski), the theoretical value of the convexity bias is found to be related to the empirically observed swap-futures differential. This is evidence of mispricing of swap rates during the earlier years of the study, with a gradual elimination of that mispricing by incorporation of a convexity adjustment in swap pricing over time.

Abstract:
We document the effects of group affiliation on the initial performance of the 2,713 Initial Public Offerings (IPOs) made in India under three different regulatory regimes during the period 1990-2004. We distinguish between two competing hypotheses regarding the effect of group affiliation on a firm's initial performance in the stock market: the certification hypothesis according to which group membership is a positive signal of firm quality, and the "tunneling" hypothesis, under which group membership affords more opportunities for the controlling shareholders to misappropriate the firm's resources, and is thus, a negative signal of firm quality. Our results show that the average underpricing of group companies is higher than that of stand-alone companies. In particular, the underpricing is high for companies affiliated to private foreign and private Indian groups. The evidence in support of the certification hypothesis is reinforced when we test the ex post performance of all IPOs: we find that, over time, group-affiliated companies have a higher probability of survival and success than their stand-alone counterparts. Groups appear to support their affiliates to maintain their reputation in the eyes of investors. However, the long-term stock market performance of firms in all categories is negative or insignificantly different from zero. Further, the long-term performance of group companies is somewhat worse than their stand-alone counterparts. We conclude that the higher underpricing of IPOs of group affiliated companies is due to investor overreaction, and may be the result of strategic behavior on the part of the groups to eliminate competition from lower quality issues.

Initial Public Offering (IPO), underpricing Indian business groups

Abstract:
We document the effects of group affiliation on the initial performance of 2,713 Initial Public Offerings (IPOs) in India under three regulatory regimes during the period 1990-2004. We distinguish between two competing hypotheses regarding group affiliation: the â¬Scertificationâ¬? and the â¬Stunnelingâ¬? hypotheses. We lend support to the latter by showing that the underpricingof group companies is higher than that of stand-alone companies. We ascribe the higher initial returns of group IPOs to investor overreaction. Ex post, we find that group-affiliated companies have a higher probability of survival over the long term: groups support their affiliates to maintain their reputation.

Initial Public Offering (IPO), Underpricing, Business Groups, Certification, Tunneling

Abstract:
We document the effects of group affiliation on the initial performance of the 2,702 IPOs made in India during three different regulatory regimes in the period 1990-2004. There are two competing hypotheses regarding the effect of group affiliation on a firm's initial performance in the stock market: the certification hypothesis according to which group membership is a positive signal of firm quality, and the "tunneling" hypothesis, under which group membership affords more opportunities for the controlling shareholders to misappropriate the firm's resources, and is thus a negative signal of firm quality. Our results show that the average underpricing of group companies is higher than that of standalone companies. In particular, the underpricing is very high for firms affiliated to foreign and domestic groups. The lowest underpricing is found for firms affiliated to the government. However, when we test the ex post performance of all IPOs, we find that group-affiliated firms tend to perform better than their standalone counterparts. Thus, it is difficult to conclude that higher underpricing is a negative signal of firm quality. We conclude that higher underpricing could be either due to investor overreaction to group-affiliated firms' IPOs, which is then reversed over time, or due to strategic behavior on the part of the groups to eliminate competition from lower quality issues.

Initial Public Offering (IPO), underpricing, business groups, certification, tunneling

Abstract:
We present a new measure of liquidity known as â¬Slatent liquidityâ¬? and apply it to a unique corporate bond database to discern the characteristics of bonds that lead to higher liquidity. Unlike conventional measures of liquidity, such as trading volume and bid-ask spreads, our measure of liquidity does not use transactional information; instead, it uses information about the ownership of securities to measure the accessibility of a security by a securities dealer. Therefore, our measure has the important advantage of being able to assess liquidity for markets with extremely low trading activity, where transactions data are insufficient to compute traditional measures of liquidity, but where liquidity is still an important issue. We relate our proposed latent liquidity measure to bond characteristics such as amount outstanding, credit quality, maturity, age, optionality and industry segment. In the liquid segments of the market, where trade-based measures of liquidity are available, our proposed measure exhibits similar relationships to bond characteristics as the trade-based measures. However, latent liquidity exhibits greater consistency in terms of its relationships with bond characteristics, over time. In addition, in the illiquid segment of the market, the relationships of our measure to bond characteristics are also similar to what we observe in the liquid segment. This leads us to believe that our measure is a viable measure of liquidity, when trade-based measures are unavailable

Abstract:
We present a new measure of liquidity known as "latent liquidity" and apply it to a unique corporate bond database to discern the characteristics of bonds that lead to higher liquidity. Unlike conventional measures of liquidity, such as trading volume and bid-ask spreads, our measure of liquidity does not use transactional information; instead, it uses information about the ownership of securities to measure the accessibility of a security by a securities dealer. Therefore, our measure has the important advantage of being able to assess liquidity for markets with extremely low trading activity, where transactions data are insufficient to compute traditional measures of liquidity, but where liquidity is still an important issue. We relate our proposed latent liquidity measure to bond characteristics such as amount outstanding, credit quality, maturity, age, optionality and industry segment. In the liquid segments of the market, where trade-based measures of liquidity are available, our proposed measure exhibits similar relationships to bond characteristics as the trade-based measures. However, latent liquidity exhibits greater consistency in terms of its relationships with bond characteristics, over time. In addition, in the illiquid segment of the market, the relationships of our measure to bond characteristics are also similar to what we observe in the liquid segment. This leads us to believe that our measure is a viable measure of liquidity, when trade-based measures are unavailable.

Abstract:
In this paper, we propose an alternative approach for pricing and hedging non-standard American options. In principle, the proposed approach applies to any kind of American-style contract for which the payoff function has a Markovian representation in the state space. Specifically, we obtain an analytic solution for the value and hedge parameters of barrier options, an important example of path-dependent options. The solution includes standard American options as a special case. The analytic formula also allows us to identify and exploit two key properties of the optimal exercise boundary - homogeneity in price parameters and time-invariance - for American options. In addition, some new put-call ``symmetry" relations are also derived. These properties suggest a new, efficient and integrated approach to pricing and hedging a variety of standard and non-standard American options. From an implementation perspective, this approach avoids the current practice of repetitive computation of option prices and hedge ratios. Our implementation of the analytic formula for barrier options indicates that the proposed approach is both efficient and accurate in computing option values and option hedge parameters. In some cases, our method is substantially faster than existing numerical methods with equal accuracy. In particular, the method overcomes the difficulty that existing numerical methods have in dealing with prices close to the barrier, the case where the barrier matters most.

Abstract:
In this paper, we propose an alternative approach for pricing and hedging Americanbarrier options. Specifically, we obtain an analytic representation for the value and hedge parameters of barrier options, using the decomposition technique of separating the European option value from the early exercise premium. This allows us to identify some new put-call "symmetry" relations and the homogeneity in price parameters of the optimal exercise boundary. These properties can be utilized to increase the computational efficiencyof our method in pricing and hedging American options. Our implementation of the obtained solution indicates that the proposed approach is both efficient and accurate in computing option values and option hedge parameters. Our numerical results also demonstrate that the approach dominates the existing lattice methodsin both accuracy and efficiency. In particular, the method is free of the difficulty that existing numerical methods have in dealing with spot prices in the proximity of the barrier, the case where the barrier options are most problematic.

Abstract:
This paper demonstrates that an an institutional feature inherent in a multitude of mutual funds managing billions in assets generates fund NAVs that reflect stale prices. Since, in many cases, investors can trade at these NAVs with little or no transactions costs, there is an obvious trading opportunity. Simple, feasible strategies generate Sharpe ratios that are sometimes one hundred times greater than the Sharpe ratio of the underlying fund. These opportunities are especially prevalent in international funds that buy Japanese or European equities and in funds that invest in thinly traded securities in the U.S. When implemented, the gains from these strategies are matched by o setting losses incurred by buy-and-hold investors in these funds. In one particular example, we explore the consequences of trading between different Vanguard mutual funds, motivated via the rules inherent in University 403B plans. Compared to an equal-weighted buy-and-hold portfolio of international Vanguard funds with a 25% cumulative return, the strategy discussed in this paper produces a 139% return while being in the stock market less than 25% of the time!

Abstract:
This paper demonstrates that an an institutional feature inherent in amultitude of mutual funds managing billions in assets generates fund NAVs that reect stale prices. Since, in many cases, investors can trade at these NAVs with little or no transactions costs, there is an obvious tradingopportunity. Simple, feasible strategies generate Sharpe ratios that are sometimes one hundred times greater than the Sharpe ratio of the underlying fund. These opportunities are especially prevalent in international funds that buy Japanese or European equities and in funds that invest in thinly traded securities in the U.S. When implemented, the gains from these strategies are matchedby o setting losses incurred by buy-and-hold investors in these funds. In one particular example, we explore the consequences of trading between different Vanguard mutual funds, motivated via the rules inherent in University 403B plans. Compared to an equal-weighted buy-and-hold portfolio ofinternational Vanguard funds with a 25% cumulative return, the strategy discussed in this paper produces a 139% return while being in the stock market less than 25% of the time!

Abstract:
In this paper, we investigate Japanese yen and U.S. dollar interest rate swap markets during the period 1990-99. We measure the spreads of the swap rates over comparable treasury yields (on Japanese Government Bonds (JGBs) and U.S. Treasury bonds, respectively) for different maturities. We then analyze the relationship between the swap spreads in the two markets.

Our main empirical results are that:(1) the correlations between yen and dollar interest swap spreads are low, indicating that the credit risk factor is country-specific, rather than global in nature, (2) dollar interest rate swaps "Granger-cause" the changes in the spreads of yen interest rate swaps for the long (ten-year) maturities, but the causality does not run the other way, and (3) yen swap spreads are highly correlated with the interest rate differentials between the two markets, and the interest rate differentials have a significant impact on subsequent movements in the yen swap spreads. These empirical results indicate that the specific institutional aspects of the yen fixed income market, such as illiquidity and market frictions, may have affected the yen interest swap rate and the swap spread.

interest rate swaps, interest rate swap spreads, relative value, international linkages, credit risk

Abstract:
We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the futures shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (¬) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.

Abstract:
We consider portfolios whose returns depend on at least three variables and show the effect of the correlation structure on the probabilities of the extreme outcomes of the portfolio return, using a multivariate binomial approximation. The portfolio risk is then managed by using derivatives. We illustrate this risk management both with simple options, whose payoff depends upon only one of the underlying variables, and with more complex instruments whose payoffs (and values) depend upon the correlation structure. The question of benchmarking portfolio performance is complicated by the use of derivatives, especially complex derivatives, since these instruments fundamentally alter the distribution of returns. We use the multivariate binomial model to set performance benchmarks for multicurrency, international, portfolios. Our model is illustrated using a simple example where a German institution invests a proportion of its funds in German equities, and the remainder in UK equities. Portfolio performance is measured in Deutsche Marks and depends upon (1) the Dax index, (2) the FTSE index, and (3) the Deutsche Mark-Sterling exchange rate. The output of the model is a simulation of possible outcomes from the portfolio hedging strategy. The difference in our methodology is that we are able to retain the simplicity of the binomial distribution, used extensively in the analysis of options, in a multivariate context. This is achieved by building three (or more) binomial trees for the individual variables and capturing the correlation structure with the use of varying conditional probabilities.

Correlation Risk, Derivatives, Portfolio Performance, Exchange Risk

Abstract:
We document the effects of group affiliation on the initial performance of 2,713 Initial Public Offerings (IPOs) in India under three regulatory regimes during the period 1990-2004. We distinguish between two competing hypotheses regarding group affiliation: the "certification" and the "tunneling" hypotheses. We lend support to the latter by showing that the underpricing of business group companies is higher than that of stand-alone companies. Furthermore, we find that the long run performance of IPOs, in general, is negative. We also find that Indian investors over-react to IPOs and their over-reaction (proxied by the oversubscription rate) explains the extent of underpricing.

Abstract:
We document the effects of group affiliation on the initial performance of the 2,713 Initial Public Offerings (IPOs) in India under three regulatory regimes during the period 1990-2004. We distinguish between two competing hypotheses regarding group affiliation and a firmâ¬"s initial stock market performance: the certification hypothesis and the â¬Stunnelingâ¬? hypothesis. We show that the underpricing of group companies is higher than that of stand-alone companies, lending support to the tunneling hypothesis. However, on an ex post basis, we find that group-affiliated companies have a higher probability of survival than their stand-alone counterparts: groups appear to support their affiliates to maintain their reputation.

Initial Public Offering (IPO), Underpricing, Business Groups, Certification

Abstract:
We investigate the interaction of volatility smiles and liquidity in the euro (¬) interest rate option markets, using daily bid and ask prices of interest rate caps/floors. We find that liquidity variables have significant explanatory power for both curvature and asymmetry of the implied volatility smiles. This effect is generally stronger on the ask side, indicating that ask-prices are more relevant for these markets. In addition, the shape of the implied volatility smile has some information about future levels and volatility of the term structure. Our results have important implications for the modeling and risk management of fixed income derivatives.

Volatility smiles, liquidity, interest rate options, euro interestrate markets, Euribor market

Abstract:
We derive general properties of two-factor models of the term structure of interest rates and, in particular, the process for futures prices and rates. Then, as a special case, we derive a no-arbitrage model of the term structure in which any two futures rates act as factors. The term structure shifts and tilts as the factor rates vary. The cross-sectional properties of the model derive from the solution of a two-dimensional autoregressive process for the short-term rate, which exhibits both mean reversion and a lagged persistence parameter. We show that the correlation of the futures rates is restricted by the no-arbitrage conditions of the model. In addition, we investigate the determinants of the volatility of the futures rates of various maturities. These are shown to be related to the volatilities of the short rate, the volatility of the second factor, the degree of mean reversion and the persistence of the second factor shock. We obtain specific results for futures rates in the case where the logarithm of the short-term rate [e.g., the London Inter-Bank Offer Rate (Libor)] follows a two-dimensional process. Our results lead to empirical hypotheses that are testable using data from the liquid market for Eurocurrency interest rate futures contracts.

Abstract:
We build a no-arbitrage model of the term structure, using two stochastic factors on each date, the short-term interest rate and the forward premium. The model is essentially an extension to two factors of the lognormal interest rate model of Black-Karazinski. It allows for mean reversion in the short rate and in the forward premium. The method is computationally efficient for several reasons. First, interest rates are defined on a bankers' discount basis, as linear functions of zero-coupon bond prices, enabling us to use the no-arbitrage condition to compute bond prices without resorting to cumbersome iterative methods. Second, the multivariate-binomial methodology of Ho-Stapleton-Subrahmanyam is extended so that a multi-period tree of rates with the no-arbitrage property can be constructed using analytical methods. The method uses a recombining two-dimensional binomial lattice of interest rates that minimizes the number of states and term structures. Third, the problem of computing a large number of term structures is simplified by using a limited number of bucket rates in each term structure scenario. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of volatilities implied by the prices of interest rate caps and floors. We illustrate the use of the model by pricing American-style and Bermudan-style options on interest rates. Option prices for realistic examples using forty time periods are shown to be computable in seconds.

Abstract:
We build a no-arbitrage model of the term structure, using two stochastic factors on each date, the short-term interest rate and the premium of the forward rate over the short-term interest rate. The model can be regarded as an extension to two factors of the lognormal interest rate model of Black-Karazinski. It allows for mean reversion in the short rate and in the forward premium. The method is computationally efficient for several reasons. First, interest rates are defined on a bankers' discount basis, as linear functions of zero-coupon bond prices, enabling us to use the no-arbitrage condition to compute bond prices without resorting to iterative methods. Second, the multivariate- binomial methodology of Ho-Stapleton-Subrahmanyam is extended so that a multiperiod tree of rates with the no-arbitrage property can be constructed using analytical methods. The method uses a recombining two-dimensional binomial lattice of interest rates that minimizes the number of states and term structures over time. Third, the problem of computing a large number of term structures is simplified by using a limited number of 'bucket rates' in each term structure scenario. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of volatilities implied by the prices of interest rate caps and floors. We illustrate the use of the model by pricing American-style and Bermudan-style options on interest rates. Option prices for realistic examples using forty time periods are shown to be computable in seconds.

Abstract:
We present a new measure of liquidity known as "latent liquidity" and apply it to a unique corporate bond database. Latent liquidity is defined as the weighted average turnover of investors who hold a bond, where the weights are the fractional investor holdings. It can be used to measure liquidity in markets with sparse transactions data. This measure exhibits relationships with bond characteristics similar to those of other trade-based measures. For bonds that trade frequently, our measure has predictive power for both transaction costs and the price impact of trading, over and above trading activity and bond-specific characteristics thought to be related to liquidity.

Abstract:
The objectives of this paper are to examine the effect of liquidity on interest rate option prices, and to determine whether it is driven by a common systematic factor. Using daily bid and ask prices of euro (¬) interest rate caps/floors, we document a negative effect of liquidity on option prices illiquid options trade at higher prices relative to liquid options, after controlling for the volatility smile and term structure variables. This is opposite to the evidence for other assets such as equities, bonds and currency options. We also identify a systematic common factor that drives liquidity, across option maturities and strike rates. This liquidity factor is driven by the changes in uncertainty in the equity and fixed income markets. Our results have important implications for the pricing and hedging of liquidity risk in derivatives markets.

Abstract:
In this paper, we present a new method for pricing and hedging American options along with an efficient implementation procedure. The proposed method is efficient and accurate in computing both option values and various option hedge parameters. We demonstrate the computation accuracy and efficiency of this numerical procedure in relation to other competing approaches. We also show how the method can be applied to the case of any American option for which a closed-form solution exists for the corresponding European option.

Abstract:
We derive a no-arbitrage model of the term structure in which any two futures rates act as factors. The term structure shifts and tilts as the factor rates vary. The cross-sectional properties of the model derive from the solution of a two-dimensional ARMA process for the short rate which exhibits mean reversion and a lagged memory parameter. We show that the correlation of the factor rates is restricted by the no-arbitrage conditions of the model. Hence in a multiple-factor model it is not valid to independently choose both the mean reversion, volatility and correlation parameters. The term-structure model, derived here, can be used to value options on bonds and swaps or to generate term structure scenarios for the risk management of portfolios of interest-rate derivatives.

Abstract:
We value American options on bonds using the Geske-Johnsan (1992). The method requires the valuation of European options with two and three possible exercise dates.It is shown that a risk-neutral valuation relationship along the lines of Black-Scholes (1973) model holds for option exercisable on multiple date, even under stochastic interest rates, when the price of the underlying asset is longormally distributed. The proposed computational procdure uses the maxmized value of these options, where the maximization is over all prossible exercise dates. The value of American option is then computed by Richardson extrapolation. The volatility of the underlying default-free bond is modelled using a two-factor model, with a short-term and a long-term interest rate factor, where the short-term interest rate is mean-reverting. Simulations show that penny accuracy is achieved with this computationally efficient method.

American Bond Options, Stochastic Interest Rates

Abstract:
In this paper, we suggest an efficient method of approximating a general, multivariate lognormal distribution by a multivariate binomial process. There are two important features of such multivariate distributions. First, the state variables may have volatilities that change over time. Second, the two or more relevant state variables involved may covary with each other in a specified manner, with a time-varying covariance structure. We discuss the asymptotic properties of the resulting processes and show how the methodology can be used to value a complex, multiple-exercisable option whose payoff depends on the prices of two assets.

Abstract:
We present a framework to analyze private placements in an extension of the Myers and Majluf (1984) model, which explicitly allows for private placements of equity to owner-managers of firms, in the context of a regulatory pricing structure. Our main conclusion is that allowing private placements to insiders can mitigate, if not eliminate, the underinvestment problem that they identify. Consequently, the empirical predictions of our model are quite different from prior models of equity valuation. Our model is particularly relevant in emerging economies, where family-controlled business groups dominate the landscape, and often, private placements to these owner-managers serve as an important channel of financing.

We empirically test the model’s predictions by using a sample of 164 private placements issued in the Indian capital market during 2001-2009. We find that virtually all the model’s predictions are borne out in the data: (1) the average price reaction to private placements is positive, (2) The average price reaction is strongly related to the regulatory restrictions on the pricing of the issue, (3) the higher the discount, the larger is the positive price reaction, and (4) firms with controlling owner-managers experience significantly lower positive price reactions.

Private Placement, Preferential Allotment, Business Groups, Underinvestment

Abstract:
An important determinant of option prices is the elasticity of the pricing kernel used to price all claims in the economy. In this paper, we first show that for a given forward price of the underlying asset, option prices are higher when the elasticity of the pricing kernel is declining than when it is constant. We then investigate the implicaitons of the elasticity of the pricing kernel for the stochastic process followed by the underlying asset. Given that the underlying information process follows a geometric. Brownian motion, we demonstrate that constant elasticity of the pricing kernel is equivalent to a Brownian motion for the forward price of the underlying asset, so that the Black-Scholes formula correctly prices options on the asset. In contast, declining elasticiy implies that the forward price process is no longer a Brownian motion: It has higher volatility and exhibits autocorrelation. In this case, the Black-Scholes formula underprices all options.

Abstract:
In this paper, we propose a general method for pricing and hedging non-standard American options. The proposed method applies to any kind of American-style contract for which the payoff function has a Markovian representation in the state space. Specifically, we obtain an analytic solution for the value and hedge parameters of path-dependent American options such as barrier options. The solution includes standard American options as a special case. The analytic formula also allows us to identify and exploit two key properties of the optimal exercise boundary-homogeneity in price parameters and time-invariance ⬠for American options. In addition, some new put-call â¬Ssymmetryâ¬? relations are also derived. These properties suggest a new, efficient and integrated approach to pricing and hedging a variety of standard and non-standard American options. From an implementation perspective, this approach avoids the current practice of repetitive computation of options prices and hedge ratios. Our implementation of the analytic formula for barrier options indicates that the proposed approach is both efficient and accurate in computing option values and option hedge parameters. In some cases, our method is faster by about four orders of magnitude than existing numerical methods with equal accuracy. In particular, the method overcomes the difficulty that existing numerical methods have in dealing with prices close to the barrier, the case where the barrier matters most.

Abstract:
In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990-96. We obtain measures of the spreads of the swap rates over comparable Japanese Government Bonds (JGBs) for different maturities and analyze the relationship between the swap spreads and credit risk variables.

Credit Risk, Japanese Government Bonds Market, Swap Pricing