Commodity Trade and the Carry Trade: A Tale of Two Countries
Robert Ready, Simon School of Business, University of Rochester
Nikolai Roussanov, The Wharton School, University of Pennsylvania
Colin Ward, Carlson School of Management, University of Minnesota
Abstract: Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high-interest rate “investment” currencies tend to be “commodity currencies,” while low interest rate “funding” currencies tend to belong to countries that export finished goods and import most of their commodities. We develop a general equilibrium model of international trade and currency pricing in which countries have an advantage in producing either basic input goods or final consumable goods. The model predicts that commodity-producing countries are insulated from global productivity shocks through a combination of trade frictions and domestic production, which forces the final goods producers to absorb the shocks. As a result, the commodity country currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the final-good producer. The carry trade risk premium increases in the degree of specialization, and the real exchange rate tracks relative technological productivity of the two countries. The model’s predictions are strongly supported in the data. Read the full paper and a feature story from Knowledge@Wharton on the research.
Equilibrium Asset Pricing with Leverage and Default
Joao Gomes, The Wharton School, University of Pennsylvania
Lukas Schmid, The Fuqua School of Business, Duke University
Abstract: We develop a general equilibrium model linking the pricing of stocks and corporate bonds to endogenous movements in corporate leverage and aggregate volatility. The model has heterogeneous firms making optimal investment and financing decisions and connects fluctuations in macroeconomic quantities and asset prices to movements in the cross-section of firms. Empirically plausible movements in leverage produce realistic asset return dynamics. Countercyclical leverage drives predictable variation in risk premia, and debt-financed growth generates a high value premium. Endogenous default produces countercyclical aggregate volatility and credit spread movements that are propagated to the real economy through their effects on investment and output. Read the full paper.
Scale and Skill in Active Management
Lubos Pastor, The University of Chicago Booth School of Business
Robert Stambaugh, The Wharton School, University of Pennsylvania
Lucian Taylor, The Wharton School, University of Pennsylvania
Abstract: We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level: As the size of the active mutual fund industry increases, a fund’s ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, though estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical fund’s lifetime. This result can also be explained by industry-level decreasing returns to scale. Read the full paper and a feature story from Knowledge@Wharton on the research presented.
Good and Bad Uncertainty: Macroeconomic and Financial Market Implications
Gill Segal, The Wharton School, University of Pennsylvania
Ivan Shaliastovich, The Wharton School, University of Pennsylvania
Amir Yaron, The Wharton School, University of Pennsylvania
Abstract: Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into ‘good’ and ‘bad’ volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk. Read the full paper and a feature story from Knowledge@Wharton on the research presented. This paper was also covered by ValueWalk.
Risk Premia, Volatilities, and Sharpe Ratios in a Nonlinear Term Structure Model
Peter Feldhutter, London Business School
Christian Heyerdahl-Larsen, London Business School
Philipp Illeditsch, The Wharton School, University of Pennsylvania
Abstract: We introduce a new reduced form term structure model where the short rate and market prices of risk are nonlinear functions of Gaussian state variables but yields are nevertheless given in closed form. Empirically, our three-factor nonlinear Gaussian model matches both the time-variation in expected excess returns and yield volatilities of U.S. Treasury bonds. During low volatility periods Treasury bonds are more attractive investments than standard Gaussian models predict. A significant part of expected excess returns in the nonlinear model is not explained by a linear combination of yields. This suggests that more information about expected excess returns is contained in the yield curve than previously thought, but in a nonlinear way. Read the full paper.