Choi, Hoyong
(2016)
Essays on asset pricing.
PhD thesis, London School of Economics and Political Science.
Abstract
The first chapter studies the impact of variance risk in the Treasury market on both term premia and the shape of the yield curve. Under minimal assumptions shared by standard structural and reduced-form asset pricing models, I show that an observable proxy of variance risk in the Treasury market can be constructed via a portfolio of Treasury options. The observable variance risk has the ability to explain the time variation in term premia, but is largely unrelated to the shape of the yield curve. Using the observable variance risk, I also propose a new representation of no-arbitrage term structure models. All the pricing factors in the model are observable, tradable, and hence economically interpretable. The representation can also accommodate both unspanned macro risks and unspanned stochastic volatility in the term structure literature.
The second chapter shows that it is beneficial to incorporate a particular zero-cost trading strategy into approaches that extract a stochastic discount factor from asset prices in a model-free manner (e.g. the Hansen-Jagannathan minimum variance stochastic discount factor). The strategy mimics the Radon-Nikodym derivative between two pricing measures with alternative investment horizons, and is hence characterized by the term structure of the SDF (or the dynamics of the SDF). Incorporating the strategy into the Euler equation significantly enhances the ability of the extracted stochastic discount factor to explain crosssectional variation of expected asset returns. Furthermore, the strategy remarkably tightens various lower bounds for the stochastic discount factor, hence setting a more stringent hurdle for equilibrium asset pricing models.
The third chapter studies variance risk premiums in the Treasury market. We first develop a theory to price variance swaps and show that the realized variance can be perfectly replicated by a static position in Treasury futures options and a dynamic position in the underlying. Pricing and hedging is robust even if the underlying jumps. Using a large options panel data set on Treasury futures with different tenors, we report the following findings: First, the term-structure of implied variances is downward sloping across maturities and increases in tenors. Moreover, the slope of the term structure is strongly linked to economic activity. Second, returns to the Treasury variance swap are negative and economically large. Shorting a variance swap produces an annualized Sharpe ratio of almost two and the associated returns cannot be explained by standard risk factors. Moreover, the returns remain highly statistically significant even when accounting for transaction costs and margin requirements.
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