Implied Interest Rates in a Market with Frictions

Naranjo, Lorenzo

doi:10.2139/ssrn.1308908

Cited by 15 publications

(9 citation statements)

References 52 publications

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“…This has implications for phenomena as diverse as index effects in the stock market, the pricing of prepayment risk in the mortgage market, the behavior of implied volatility surfaces in the options market, and the behavior of risk premia in the government bond market. Hau (2009b), Jylha & Suominen (2009) and Plantin & Shin (2009) pursue similar themes for the foreign exchange market, and Naranjo (2009) does so for the futures market.…”

Section: Summary and Next Stepsmentioning

confidence: 94%

Limits of Arbitrage: The State of the Theory

Gromb

Vayanos

2010

SSRN Journal

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for helpful comments, and the Paul Woolley Centre at the LSE for financial support. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

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Section: Summary and Next Stepsmentioning

confidence: 94%

Limits of Arbitrage: The State of the Theory

Gromb

Vayanos

2010

SSRN Journal

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“…The middle case assumed borrowing at the three-month Eurodollar deposit rate starting in 1971 and at the risk-free rate plus 60 bps before 1971. The rationale for these assumptions stems from Naranjo (2009), who concluded that investors using futures borrow at LIBOR, on average. Because LIBOR is available only from 1987 on, Eurodollar deposit rates are available from 1971 on, and three-month LIBOR and the three-month Eurodollar deposit rate track one another closely over the period of overlap, we opted to use Eurodollar deposit rates in our study.…”

Section: Strategiesmentioning

confidence: 99%

“…In the experiments discussed in the previous section, we financed the levered risk parity strategy at the 90-day T-bill rate, but that approach is not possible in practice. Naranjo (2009) demonstrated that in the most recent decade, LIBOR has been a more realistic estimate of the implicit interest rate at which investors can lever by using futures. Because it is available over a longer period, we used the U.S. three-month Eurodollar deposit rate as a proxy for LIBOR.…”

Section: Effect Of Transaction Costs On Apparent Outperformancementioning

confidence: 99%

Will My Risk Parity Strategy Outperform?

Anderson

Bianchi

Goldberg

2012

Financial Analysts Journal

103

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Past performance is not a guarantee of future returns. This familiar disclaimer highlights the fact that a particular investment strategy may work well in some periods and poorly in others, limiting the inference that can be drawn from past returns.The concern is heightened when a proposed investment strategy is backtested by using historical data. Consider an investment strategy that can be pursued today with readily available securities. If those securities were unavailable in the past, then the strategy has no true antecedent. Backtesting must be conducted with proxies for the securities, and the choice of proxies can have a direct effect on measured returns. In addition, the introduction of new securities can have an indirect effect; a strategy that was seemingly profitable in the past might have been less profitable if the new securities had been available and thus made the strategy accessible to a broader class of investors. The matter is confounded by the specific attributes of the backtesting period, concerns about statistical significance, and a plethora of metrics used by investors to evaluate strategy performance.In our study, we considered these issues by carefully examining the historical performance of four simple strategies based on two asset classes: U.S. equity and U.S. Treasury bonds. 1 We included a market or value-weighted portfolio, which is the optimal risky portfolio in the capital asset pricing model (CAPM), and a 60/40 mix, which is popular with pension funds and other long-horizon investors. We also included two risk parity strategies. Risk parity attempts to equalize risk contributions across asset classes; early formulations of risk parity can be found in and Kessler and Schwarz (1996). 2 Risk parity has been popular since the 2008 financial crisis, as frustrated investors have struggled to meet return targets by levering low-risk or low-beta assets, and it is sufficiently mainstream to be featured in the Wall Street Journal. 3 A diverse collection of risk parity strategies can be constructed by varying asset classes, grouping schemes, and risk estimates. 4 An essential element of risk parity is leverage, which distinguishes the two risk parity strategies in our study. Because an unlevered risk parity strategy tends to have relatively low risk and thus relatively low expected return, a risk parity strategy must be levered in order to have even a remote chance of achieving a typical return target. 5 The notion that levering a low-risk portfolio might be worthwhile dates back to Black, Jensen, and Scholes (1972), who provided empirical evidence that the risk-adjusted returns of low-beta equities are higher than the CAPM would predict. Black (1972) introduced a zero-beta portfolio, considered by some to be the antecedent of risk parity. Nearly four decades later, Frazzini and Pedersen (2010) developed a compelling theory of leverage aversion in which risk parity emerges as a dominant strategy, and this dominance is supported by the empirical study in Asness, Frazzini, and Pedersen (201...

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“…However, these rates are either not available for longer maturities, or empirically lie between Treasury rates and swap rates (Naranjo, 2009). We therefore focus on plainvanilla interest rate swap rates.…”

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confidence: 99%

Investor sentiment, flight-to-quality, and corporate bond comovement

Bethke

Gehde-Trapp

Kempf

2017

Journal of Banking & Finance

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractWe examine the dynamics of bond correlation using a broad sample of US corporate bonds, and document that bond correlation varies heavily over time. We attribute this variation in bond correlation to variation in risk factor correlation reflecting time-varying flight-to-quality behavior of investors. We show that risk factor correlation increases when investor sentiment decreases, i.e., corporate bond investors exhibit stronger flight-to-quality when their sentiment is low. Thus, low investor sentiment leads to flightto-quality behavior and, ultimately, high bond correlation.JEL classification: G11; G12

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Implied Interest Rates in a Market with Frictions

Cited by 15 publications

References 52 publications

Limits of Arbitrage: The State of the Theory

Limits of Arbitrage: The State of the Theory

Will My Risk Parity Strategy Outperform?

Investor sentiment, flight-to-quality, and corporate bond comovement

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