Option-Implied Ambiguity and The Cross-section of Asset Pricing

This study investigates the relevance for asset pricing of a new candidate for a state variable that could forecast changes in the investment opportunity set. I introduce an option-implied measure of heterogeneity in investors’ expectations based on the concept of entropy. The forecasting power for returns of the new measure is comparable with the implied volatilities generated from stochastic volatility models of Heston (1993) and Heston Nandi (2000). The cross-sectional significance of this measure is tested in a multi-factor setting. The factor-augmented models tested in this study capture a dispersion risk that CAPM or Fama-French 3-factor model fail to capture. Unlike the previous studies that found support for the theory of Miller (1977), I found support for the theory of Merton (1987) which stipulates that dispersion in expectations is a proxy for risk and investors require to be compensated for it. The heterogeneity factor seems more important than the liquidity factor of Pastor and Stambaugh (2003) and has closed results to the momentum factor of Carhart (1997), suggesting that an important source of momentum is due to heterogeneity. The results confirm that accounting for heterogeneous expectations is important in explaining the cross section of returns.

Causality and Asymmetric Linkages between Hazard Rates and the Macro Environment

This study uses the hazard rates of specific firms to construct a direct proxy for the credit risk in a reduced form framework. This credit risk measure is used to investigate the nonlinear causality and asymmetric correlations within the macroeconomic environment. Following recent advances in empirical macroeconomics, the information from a large set of economic indicators is extracted using the dynamic factor analysis. The results show significant nonlinear causality from the credit risk information to the economy. On the other hand, only a small portion of the credit risk is explained by indicators of economic activity. This study points out the existence of extreme asymmetric correlations between the bond and the overall economy, suggesting potential applications to risk management and forecasting. I also find that macroeconomic news variables are statistically significant in explaining the median correlation between the hazard rate and the macro factors

Growth Options and the Term Structure of Credit Spreads

The value of the firm is a key ingredient in any structural credit risk model. This study introduces a theoretical approach based on Collin-Dufresne Goldstein (2001) and Demchuk and Gibson (2006), by decomposing the value of the firm into assets in place and growth options. The new model allow disentangling between the idiosyncratic and the systematic components of default, and offer a theoretical motivation regarding the importance of firm specific non-defaultable factors in explaining the level of credit spreads. The structural credit risk model incorporating growth opportunities is able to explain a larger proportion of the observed credit spreads when comparing to the existing structural models.

Real Options and Credit Spreads (with Pascal Francois)

This study develops a set of structural credit risk models by adding growth opportunities to the classical (assets-in-place only) model of Merton (1974). The contribution of this study is two-fold. First (semi) closed form solutions are derived for the credit spreads in the new credit risk models augmented with growth opportunities. Second, the new models are tested empirically using a sample of CDS prices for a large number of firms. The results indicate that the accounting for growth opportunities is a significant step forward in solving the credit risk puzzle.