Asset Pricing Theory
Session Chair: Jun Yu, University of Melbourne
Volatility Disagreement and Equilibrium Volatility Trading
Adem Atmaz; Purdue University
Andrea Buffa; University of Colorado Boulder
We develop a dynamic equilibrium model in which investors disagree on future volatility and trade volatility derivatives to hedge their stock positions and speculate on their beliefs. We find that in equilibrium investors trade less volatility derivatives in more volatile periods, and they may also do so when they disagree more. The variance risk premium is negative on average, but it becomes positive when the market tends to underestimate future volatility. Volatility disagreement generates time-variation in the leverage effect, which gets stronger in more volatile periods, consistent with empirical evidence. Our framework, which can also incorporate an aggregate volatility bias, reconciles other key aspects of volatility derivatives and stock markets in a unified setting.
Discussant: Lei Shi, Macquarie University
A unified explanation for the decline of the value premium and the rise of the mark
Xiaoji Lin; University of Minnesota
Chao Ying; The Chinese University of Hong Kong
Tian Yao (Terry) Zhang; Australian National University
The ability of recent three- to six-factor models to explain the cross-section of stock returns varies substantially over time, providing scope for time-varying numbers of additional significant factors. Out-of-sample Sharpe ratios formed from principal components of factors identified in-sample are economically large and continue to increase up to about thirty factor principal components, implying that many factors are both economically important and non-redundant. The number of significant factors is strongly related to variation in economic conditions and measures of diversity in firm characteristics. These results suggest that time variation in the number of significant factors reflects time-varying economic complexity.
Discussant: Alexandre Corhay, Rotman School of Management, University of Toronto