Strategic Trading When Central Bank Intervention Is Predictable

Market prices are noisy signals of economic fundamentals. In a two-period model, we show that if the central bank uses market prices as guidance for intervention, large, strategic investors who benefit from high prices would depress market prices to induce a market-supportive intervention. Stronger anticipated interventions lead to deeper price depressions preintervention and sharper price reversals post- intervention. The central bank intervention harms strategic investors even though it is the investors who tried to mislead the central bank. The model predicts a V-shaped price pattern around central bank interventions, consistent with recent evidence. (JEL G14, G18)

Investing in Socially Responsible Mutual Funds

We construct optimal portfolios of mutual funds whose objectives include socially responsible investment (SRI). Comparing portfolios of these funds to those constructed from the broader fund universe reveals the cost of imposing the SRI constraint on investors seeking the highest Sharpe ratio. This SRI cost crucially depends on the investor’s views about asset pricing models and stock-picking skill by fund managers. To an investor who strongly believes in the CAPM and rules out managerial skill, that is, a market index investor, the cost of the SRI constraint is typically just a few basis points per month, measured in certainty-equivalent loss. To an investor who still disallows skill but instead believes to some degree in pricing models that associate higher returns with exposures to size, value, and momentum factors, the SRI constraint is much costlier, typically by at least 30 basis points per month. The SRI constraint imposes large costs on investors whose beliefs allow a substantial amount of fund-manager skill, that is, investors who heavily rely on individual funds’ track records to predict future performance.

Dynamic Asset Pricing with Interactions between Short-Sale and Borrowing Constraints

This paper studies the joint effect of borrowing and short-sale constraints under heterogeneous beliefs and risk aversions. Although the constraints never simultaneously bind in equilibrium, interesting economics emerge in the anticipatory effects of potentially future binding constraints. In particular, the risk-free rate and Sharpe ratio experience endogenous jumps at a critical state, where two equilibria coexist. Moreover, a short-sale ban can lead to a lower stock price and higher volatility depending on the relative tightness between the constraints, and tightening the borrowing constraint during a short-sale ban can also make returns more volatile.

CDS Momentum: Slow-Moving Credit Ratings and Cross-Market Spillovers

This paper highlights the adverse consequences of sluggish credit rating updates in creating information efficiency distortions and investment anomalies. We first document significant credit default swap (CDS) return momentum yielding 7.1% per year. We further show that cross-market momentum strategies based on information in past CDS performance generates an alpha of 10.3% per year in stocks and 7.3% per year in bonds. These CDS momentum and cross-market effects are stronger among more liquid, informationally rich CDS contracts whose CDS spreads move in anticipation of important, yet slow-moving, credit rating changes.

Zero-Coupon Yields and the Cross-Section of Bond Prices

I estimate a dynamic term structure model on an unbalanced panel of Treasury coupon bonds, without relying on an interpolated zero-coupon yield curve. A linearity-generating model, which separates the parameters that govern the cross-sectional and time-series moments of the model, takes about 8 min to estimate on a sample of over 1 million bond prices. The traditional exponential affine model takes about 2 hr, because of a convexity term in coupon-bond prices that cannot be concentrated out of the cross-sectional likelihood. I quantify the on-the-run premium and a “notes versus bonds” premium from 1990 to 2017 in a single, easy-to-estimate no-arbitrage model.