We analyze 18 quadrillion models for the joint pricing of corporate bond and stock returns. Strikingly, we find that equity and nontradable factors alone suffice to explain corporate bond risk premia once their Treasury term structure risk is accounted for, rendering the extensive bond factor literature largely redundant for this purpose. While only a handful of factors, behavioral and nontradable, are likely robust sources of priced risk, the true latent stochastic discount factor is dense in the space of observable factors. Consequently, a Bayesian Model Averaging Stochastic Discount Factor explains risk premia better than all low-dimensional models, in- and out-of-sample, by optimally aggregating dozens of factors that serve as noisy proxies for common underlying risks, yielding an out-of-sample Sharpe ratio of 1.5 to 1.8. This SDF, as well as its conditional mean and volatility, are persistent, track the business cycle and times of heightened economic uncertainty, and predict future asset returns.

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We study the impact of political uncertainty on exchange rates and the pricing of currency options. While we do not find clear directional patterns in exchange rates, option prices reflect the heightened political uncertainty around elections and referendums for a cross-section of 30 countries. In general, FX options whose lives span political events are more expensive, with the effect being even stronger for options that protect against domestic currency depreciation.

ABSTRACTThe U.S. dollar appreciates in the run‐up to foreign exchange (FX) fixes and depreciates thereafter, tracing a W‐shaped return pattern around the clock. Return reversals for the top nine traded currencies over a 21‐year period are pervasive and highly statistically significant, and they imply daily swings of more than one billion U.S. dollars based on spot volumes. Using natural experiments, we document the existence of a published reference rate determines the timing of intraday return reversals. We present evidence consistent with an inventory risk explanation whereby FX dealers intermediate unconditional demand for U.S. dollars at the fixes.

Recent studies document strong empirical support for multifactor models that aim to explain the cross-sectional variation in corporate bond expected excess returns. We revisit these findings and provide evidence that common factor pricing in corporate bonds is exceedingly difficult to establish. Based on portfolio- and bond-level analyses, we demonstrate that previously proposed bond risk factors, with traded liquidity as the only marginal exception, do not have any incremental explanatory power over the corporate bond market factor. Consequently, this implies that the bond CAPM is not dominated by either traded- or nontraded-factor models in pairwise and multiple model comparison tests.

We show that firm default risk is the primary predictor of the comovement between corporate bond and stock returns, both in the cross-section and over time. Intuitively, bonds of less creditworthy firms behave more like the issuing firms’ stocks, resulting in higher future comovement. We find that investing in bonds and stocks of the most creditworthy firms significantly enhances diversification benefits and Sharpe ratios out-of-sample. We develop a structural model with stochastic asset variance that rationalizes these findings. The model is consistent with salient asset pricing and default risk moments and contributes to understanding the forces driving stock-bond comovement.

Uncertainty about future policy rates plays a crucial role for the transmission of monetary policy to financial markets. We demonstrate this using event studies of FOMC announcements and a new model-free uncertainty measure based on derivatives. Over the 'FOMC uncertainty cycle' announcements systematically resolve uncertainty, which then gradually ramps up again. Changes in monetary policy uncertainty around FOMC announcements-often due to forward guidance-have pronounced effects on asset prices that are distinct from the effects of conventional policy surprises. The level of uncertainty determines the magnitude of financial market reactions to surprises about the path of policy rates.

In this paper we investigate the price, volatility and micro-level effects of central bank swap lines during the 2020 pandemic. Following swap line auctions, these interventions reduced the level and volatility of covered interest rate parity violations. We combine dealer-level dollar auctions by the Bank of England with FX derivative transactions. Dealers that used the swap line engaged in more favorable pricing of forward contracts, reduced their gross FX exposures, and increased their net supply of dollars to nonfinancial institutions. Taken together, our results support the rationale for swap lines in reducing mis-pricing in FX markets and providing cross-border liquidity.

Productive firms can access credit markets directly by issuing corporate bonds or by borrowing through financial intermediaries. In this paper, we study the cyclical properties of corporate credit provision through these two types of debt instruments in major advanced economies. We argue that the cyclicality of corporate credit is closely related to the cyclicality of the types of financial intermediaries active in the provision of credit. When a debt instrument is held by institutions that manage their balance sheets through debt issuance, credit provision through that instrument is procyclical. But when a debt instrument is held by institutions that manage their balance sheets through equity issuance, credit provision through that instrument is countercyclical. We show that cross-country differences in the cyclicality of corporate credit can be ascribed to differences in the composition of the aggregate financial sector, and not to differences in the balance sheet management practices of each type of financial intermediary.

In the short-run, bond risk premia exhibit pronounced spikes around major economic and financial crises. In contrast, long-term bond risk premia feature cyclical swings. We empirically examine the predictability of the market variance risk premium-a proxy of economic uncertainty-for bond risk premia and we show the strong predictive power for the one-month horizon that quickly recedes for longer horizons. The variance risk premium is largely orthogonal to well-established bond return pre-dictors-forward rates, jumps, and macro variables. We rationalize our empirical findings in an equilibrium model of uncertainty about consumption and inflation which is coupled with recursive preferences. We show that the model can quantitatively explain the levels of bond and variance risk premia as well as the predictive power of the variance risk premium, while jointly matching salient features of other asset prices.

We test the role of funding-constrained investors across developed financial markets. We compile direct measures of the severity of funding frictions, or illiquidity, from deviations of government bond yields from a fitted yield curve. Using these illiquidity measures, we first show that higher illiquidity is associated with a flatter security market line across markets. Exploiting the cross-section, we find that cross-country variation in illiquidity is associated with cross-country variation in alpha, in line with our theoretical predictions. Finally, we estimate a significant negative illiquidity risk premium that reveals a strong willingness of investors to hedge against the deterioration of funding conditions.

Preand Post-Announcement Returns: Table IA.I reports results of regressing individual currency returns on the announcement dummy over three different time windows: the entire day (4pm to 4pm), the pre-announcement window (4pm to 215pm), and the post-announcement window (215pm to 4pm). The results for the entire day, reported in Panel A, are in line with those presented in Table I in the main article: the difference between announcementand nonannouncement-day returns is statistically different from zero for all currencies except for the Japanese yen and the Norwegian krona. Panels B and C report the estimated coefficients for the announcement dummy for returns over the preand post-announcement windows, respectively. As the table shows (and consistent with our results for interest rate-sorted portfolios in Table IV in the main article), the difference between announcementand nonannouncement-day returns is positive and significant for a majority of the individual currencies over both time windows.

We propose a direct and robust method for quantifying the variance risk premium on financial assets. We theoretically and numerically show that the risk-neutral expected value of the return variance, also known as the variance swap rate, is well approximated by the value of a particular portfolio of options. Ignoring the small approximation error, the difference between the realized variance and this synthetic variance swap rate quantifies the variance risk premium. Using a large options data set, we synthesize variance swap rates and investigate the historical behavior of variance risk premia on five stock indexes and 35 individual stocks.

We document that a trading strategy that is short the U.S. dollar and long other currencies exhibits significantly larger excess returns on days with scheduled Federal Open Market Committee (FOMC) announcements. We also show that these excess returns (i) are higher for currencies with higher interest rate differentials vis-a-vis the U.S.; (ii) increase with uncertainty about monetary policy; and (iii) intensify when the Federal Reserve adopts a policy of monetary easing. We interpret these excess returns as a compensation for monetary policy uncertainty within a parsimonious model of constrained financiers who intermediate global demand for currencies.

We show that the cross-sectional dispersion of conditional foreign exchange (FX) correlation is countercyclical and that currencies that perform badly (well) during periods of high dispersion yield high (low) average excess returns. We also find a negative cross-sectional association between average FX correlations and average option-implied FX correlation risk premiums. Our findings show that while investors in spot currency markets require a positive risk premium for exposure to high dispersion states, FX option prices are consistent with investors being compensated for the risk of low dispersion states. To address our empirical findings, we propose a no-arbitrage model that features unspanned FX correlation risk.

We build a parsimonious international asset pricing model in which deviations of government bond yields from a fitted yield curve of a country measure the tightness of investors' capital constraints. We compute these measures at daily frequency for six major markets and use them to test the model-predicted effect of funding conditions on asset prices internationally. Global illiquidity lowers the slope and increases the intercept of the international security market line. Local illiquidity helps explain the variation in alphas, Sharpe ratios, and the performance of betting-against-beta (BAB) strategies across countries.

We study equity (EVRP) and Treasury variance risk premia (TVRP) jointly and document a number of findings: First, relative to their volatility, TVRP are comparable in magnitude to EVRP. Second, while there is mild positive co-movement between EVRP and TVRP unconditionally, time series estimates of correlation display distinct spikes in both directions and have been notably volatile since the financial crisis. Third $(i)$ short maturity TVRP predict excess returns on short maturity bonds; $(ii)$ long maturity TVRP and EVRP predict excess returns on long maturity bonds; and $(iii)$ while EVRP predict equity returns for horizons up to 6-months, long maturity TVRP contain robust information for long run equity returns. Finally, exploiting the dynamics of real and nominal Treasuries we document that short maturity break-even rates are a power determinant of the joint dynamics of EVRP, TVRP and their co-movement. We argue this result is consistent with an economy in which derivative markets embed fears about deflation.

We study feedback from the risk of outstanding mortgage-backed securities (MBS) on the level and volatility of interest rates. We incorporate supply shocks resulting from changes in MBS duration into a parsimonious equilibrium dynamic term structure model and derive three predictions that are strongly supported in the data: (1) MBS duration positively predicts nominal and real excess bond returns, especially for longer maturities; (2) the predictive power of MBS duration is transitory in nature; and (3) MBS convexity increases interest rate volatility, and this effect has a hump-shaped term structure.

The Online Appendix contains additional results not includ ed in the main paper. In Section OA-1, we show that our FX correlation dispersion measure FXC is very robust to di fferent choices regarding its construction. Section OA-2 shows that our cross-sectional asset pricing tests are robu st to sing the non-traded ∆FXC factor instead of the traded HMLC factor and to using di fferent sample periods and sample currencies. In Section OA-3 , we confirm that our cross-sectional results with respect to the FX correlation risk premiums are robust to alternative construction metho ds. In Section OA-4, we discuss the e ff ct of jumps on implied FX correlation measures. Section OA5 presents summary statistics for FX variances and FX variance risk premiums. S ection OA-6 shows that sorting on exposure to the FX correlation risk factor is not subsumed by exposure to an FX v ariance risk factor. Finally, Section OA-7 explores the spanning properties of FX correlation risk. OA-1. Alternative construction of FXC In the paper, we document a strong cross-sectional associat ion between the average level and the cyclicality of conditional FX correlation: high average correlation FX pa irs become even more correlated during bad times, whereas the correlation of low correlation FX pairs falls. This empi rical result motivates the use of our FX correlation dispers ion measureFXC, which is defined as the di fference in average conditional FX correlation between the to p and the bottom deciles of FX pairs sorted on their conditional correlation . [Insert Figure OA-1 here.] Instead of using deciles, we can alternatively construct th e measure as the di fference in correlations between the top and bottom quintiles or quartiles ( FXCQuintile andFXCQuartile, respectively). Increasing the size of the top and bottom groups reduces the correlation spread and, thus, the averag e level of the dispersion measure. In Panel A of Figure OA-1, we plot the original measure, along with the two altern ative measures. Both alternative measures are very highly correlated with the original measure, both in levels (0.99 a nd 0.98, respectively, for FXCQuintile andFXCQuartile) and in first differences (0.95 and 0.94, respectively). Not surprisingly, t he portfolio results are very robust to using the alternative measures: Panels B and C present three G10 curre n y portfolios sorted on the alternative ∆FXC betas for various sample periods. The results for both alternative me asures are qualitatively the same as those for the original measure. In particular, for all subsamples, excess currenc y returns are decreasing in the ∆FXC betas and the spread between the high and the low ∆FXC beta portfolio is substantial and statistically significan t. OA-2. Cross-sectional asset pricing In Table 10 of the main paper, we present estimates of the mark et p ice of FX correlation risk using various test assets. Table OA-1 contains the first-stage regression esti mates for test asset sets (3) and (4) that are omitted in Table 10. Email addresses: p.mueller@lse.ac.uk (Philippe Mueller),astath@uw.edu (Andreas Stathopoulos), a.vedolin@lse.ac.uk (Andrea Vedolin) Preprint submitted to Journal of Financial Economics October 26, 2016 [Insert Table OA-1 here.] Instead of usingHMLC returns, a traded factor, we can also perform our asset prici ng tests using the non-traded factor∆FXC. Figure OA-2 illustrates the performance of the ∆FXC factor by plotting the predicted annualized excess returns for various test assets (G10 currencies in Panel A, c urrency portfolios using all currencies and developed country currencies, in Panels B and C, respectively) agains t the actual annualized mean excess returns. Compared with the results when using the traded factor HMLC , the second-stage regression R2s are lower, but still high: 0.79, 0.78 and 0.58, respectively. Table OA-2 compares the estimates f or the market prices of risk of two factors, HMLC returns andFXC innovations, for the samples of all currencies and develope d country currencies, using eight test assets (four currency portfolios sorted on FX correlation betas and four cur ency portfolios sorted on nominal interest rates) in each case. We consider three sample periods for each specific ation: January 1996 to December 2013, January 1984 to December 2013, and January 1996 to July 2007. Our results a re fairly robust across alternative sample periods and factor specifications. In particular, the market price o f risk for the non-traded correlation factor ∆FXC is always negative and often significant. Compared to our benchmark sa mple period (January 1996 to December 2013), the results for the January 1984 to December 2013 sample are slig htly weaker, while the price of risk estimates when we exclude the financial crisis (January 1996 to July 2007) are s trongly significant. Overall,FXC innovations perform reasonably well in pricing the cross section of currency ret urns, albeit somewhat worse than our traded factor, HMLC returns. [Insert Figure OA-2 and Table OA-2 here.] OA-3. Alternative definitions for FX correlation risk premi ums In the paper, we show that average FX correlation risk premiu ms and average FX correlations are negatively related in the cross section of FX pairs. We measure FX correlation ri sk premiums using information available at time t: we calculate the conditional risk-neutral correlations usin g currency option prices observed at time t, while our proxy for conditional correlations under the physical measure is the average realized correlation over the three-month period ending att, sampled daily. Instead of using a three-month window, we ca n instead proxy for the conditional FX correlations under the physical measure using an one-month wi dow of past daily exchange rates (i.e., daily data from t − 1 to t), or using an one-month window of future daily exchange rate s (i. ., daily data fromt to t + 1). Figure OA-3 provides scatter plots of average FX correlation risk premi ums against the average FX correlations constructed using each of those two alternative measures of physical measure c onditional FX correlations: Panel A refers to measures constructed using data over the month ending at t, whereas Panel B refers measures constructed using data bet weent andt + 1. As we can see, the negative cross-sectional association b etween average FX correlation risk premiums and average FX correlations is robust to alternative measures o f conditional FX correlation under the physical measure. [Insert Figure OA-3 here.] OA-4. The effect of jumps on implied FX correlation To construct the measures of model-free implied exchange ra te moments, we follow the methodology of Britten-Jones and Neuberger (2000). They impose no-arbitr ge conditions and show that the risk-neutral expected return variance of an underlying asset is fully specified by a continuum of call and put options on that asset, provided that the price of the underlying asset is a di ffusion process. Given recent empirical evidence of priced ju mp risk in exchange rates (see, e.g., Chernov, Graveline, and Zviadad ze (2016)), it is natural to ask whether that methodology remains valid when the underlying price process includes ju mps. In the following, we address this question in two ways. First, we show that the Britten-Jones and Neuberger (2 000) methodology is valid even in the presence of jumps, provided that the higher order moments of the jump distribut ion are not very large. Second, we also consider the approach of Martin (2016), who derives a measure of risk-neu tral expected variance that is robust to jumps, and we