Using dealer’s quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross-correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply0 demand shocks that are independent of both credit-risk factors and standard proxies for liquidity.

Implicit in the prices of traded financial assets are Arrow-Debreu prices or, with continuous states, the state-price density (SPD). We construct a nonparametric estimator for the SPD implicit in option prices and derive its asymptotic sampling theory. This estimator provides an arbitrage-free method of pricing new, complex, or illiquid securities while capturing those features of the data that are most relevant from an asset-pricing perspective, e.g., negative skewness and excess kurtosis for asset returns, volatility "smiles" for option prices. We perform Monte Carlo experiments and extract the SPD from actual S&P 500 option prices.

In this paper we analyze the pricing and hedging of caps and swaptions using term structure models. Cap prices mainly depend on variances of forward interest rates, whereas swaption prices also depend on the correlations between these forward rates. We therefore compare onefactor models, that imply perfectly correlated interest rates, with multi-factor models, using US data on cap and swaption prices for 1995 until 1999. The caps and swaptions data contain wide ranges of both option maturities and maturities of the underlying interest rates and swaps. The models are estimated using either historical interest rate data or derivative prices. We compare the different models by analyzing the accuracy of predicting caps and swaption prices and the accuracy of hedging caps and swaptions. We find that models with two or three factors imply more accurate predictions for cap and swaption prices and more accurate hedging of caps and swaptions than one-factor models. However, the differ...

Investors value the liquidity and safety of U.S. Treasury bonds. We document this by showing that changes in Treasury supply have large effects on a variety of yield spreads. As a result, Treasury yields are reduced by 72 basis points, on average over the period from 1926-2008. The low yield on Treasuries due to their extreme safety and liquidity suggests that Treasuries in important respects are similar to money. Evidence from quantities supports this idea. When the supply of Treasuries falls, reducing the overall supply of liquid and safe assets, the supply of bank-issued money rises.

and the Workshop on Capital Structure Arbitrage at the University of Evry. We are particularly grateful for the comments and suggestions of Jun Liu, the Editor We conduct an analysis of the risk and return characteristics of a number of widelyused fixed income arbitrage strategies. We find that the strategies requiring more “intellectual capital ” to implement tend to produce significant alphas after controlling for bond and equity market risk factors. These positive alphas remain significant even after taking into account typical hedge fund fees. In contrast with other hedge fund strategies, many of the fixed income arbitrage strategies produce positively skewed returns. These results suggest that there may be more economic substance to fixed income arbitrage than simply “picking up nickels in front of a steamroller.

We identify a class of term structure models possessing a generalized affine-structure that significantly extends the class studied by Duffie, Pan and Singleton (2000). For this class of...

We conduct an analysis of the risk and return characteristics of a number of widely used fixed-income arbitrage strategies. We find that the strategies requiring more ‘‘intellectual capital’ ’ to implement tend to produce significant alphas after controlling for bond and equity market risk factors. These positive alphas remain significant even after taking into account typical hedge fund fees. In contrast with other hedge fund strategies, many of the fixed-income arbitrage strategies produce positively skewed returns. These results suggest that there may be more economic substance to fixedincome arbitrage than simply ‘‘picking up nickels in front of a steamroller.’’ During the hedge fund crisis of 1998, market participants were given a revealing glimpse into the proprietary trading strategies used by a number of large hedge funds such as Long-Term Capital Management (LTCM). Among these strategies, few were as widely used—or as painful—as fixedincome arbitrage. Virtually every major investment banking firm on Wall Street reported losses directly related to their positions in fixed-income arbitrage during the crisis. Despite these losses, however, fixed-income arbitrage has since become one of the most popular and rapidly growing sectors within the hedge fund industry. For example, the Tremont/TASS (2005) Asset Flows Report indicates that total assets devoted to fixed-income arbitrage grew by more than $9.0 billion during 2005 and that the total We are grateful for valuable comments and assistance from Vineer Bhansali, Charles Cao, Darrell Duffie,

Myers for research assistance. All errors are my responsibility. We study the optimal recursive refinancing problem where a borrower minimizes his lifetime mortgage costs by repeatedly refinancing when rates drop sufficiently. Key factors affecting the optimal decision are the cost of refinancing and the possibility that the mortgagor may have to refinance at a premium rate because of his credit. The optimal recursive strategy often results in prepayment being delayed significantly relative to traditional models. Furthermore, mortgage values can exceed par by much more than the cost of refinancing. Applying the recursive model to an extensive sample of mortgage-backed security prices, we find that the implied credit spreads that match these prices closely parallel borrowers’ actual spreads at the origination of the mortgage. These results suggest that optimal recursive models may provide a promising alternative to the reduced-form prepayment models widely used in practice. 1.

Previous literature has found that stock returns comove more than fundamentals. More recently, researchers have also found commonalities in liquidity and trading activity. In this paper, I document the role of institutional clienteles in comovement. To define clienteles, I take an innovative approach based on applying hierarchical clustering algorithms to institutional holdings. I find the majority of institutional investors can be stably clustered into a small number of clienteles. These clienteles seem to play an important role in explaining comovement. Stocks hold by the same clientele comove excessively in trading volume, return, and liquidity. Lastly, I provide a channel through which clientele effects generate comovement. Funds within the same clientele seem suffer correlated liquidity shocks. These shocks generate correlated order flow in the underlying stocks, inducing comovement in return and liquidity for these stocks. 1 th

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