Many important classes of assets are illiquid in the sense that they cannot always be traded immediately. Thus, a portfolio position in these types of illiquid investments becomes at least temporarily irreversible. We study the asset-pricing implications of illiquidity in a two-asset exchange economy with heterogeneous agents. In this market, one asset is always liquid. The other asset can be traded initially, but then not again until after a “blackout” period. Illiquidity has a dramatic effect on optimal portfolio decisions. Agents abandon diversification as a strategy and choose highly polarized portfolios instead. The value of liquidity can represent a large portion of the equilibrium price of an asset. We present examples in which a liquid asset can be worth up to 25 percent more than an illiquid asset even though both have identical cash flow dynamics. We also show that the expected return and volatility of an asset can change significantly as the asset becomes relatively more liquid.

We examine whether there is a flight-to-liquidity premium in Treasury bond prices by comparing them with prices of bonds issued by Refcorp, a U.S. Government agency. Since Refcorp bonds are, in effect, guaranteed by the Treasury, they have the same credit as Treasury bonds. We find a large liquidity premium in Treasury bonds, which can be more than fifteen percent of the value of some Treasury bonds. We find strong evidence that this liquidity premium is related to changes in consumer con- fidence, flows into equity and money market mutual funds, and changes in foreign ownership of Treasury debt. This suggests that the popularity of Treasury bonds directly affects their value

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.

We develop a simple closed 0form valuation model for options when the volatility of the underlying asset is stochastic. Out approach differs from previous research in that we model the pricing density directly. We show that implied volatility estimates from the Black-Scholes model can be very misleading, even when at-the-money options are used in the estimation. We also illustrate that the smile effect in index option prices can be explained by allowing changes in volatility to be correlated with index returns.

Economic shocks affect corporate cash flows far more than they do aggregate consumption. We examine the asset-pricing implications of corporate sensitivity to shocks using a continuous-time representative agent framework in which earnings are a stochastic fraction of total consumption. We provide closed-form solutions for equity values when earnings and consumption follow exponential-affine jump-diffusion processes. Calibrating the model to historical data, we show that the extreme sensitivity of corporate cash flows to shocks dramatically increases the equity premium. The model implies realistic values for the equity premium given modest levels of risk aversion and generates levels of equity volatility consistent with those experienced by the stock

In theory, an investor can make infinite profits by taking unlimited positions in an arbitrage. In reality, however, investors must satisfy margin requirements which completely change the economics of arbitrage. We derive the optimal investment policy for a risk-averse investor in a market where there are arbitrage opportunities. We show that it is often optimal to underinvest in the arbitrage by taking a smaller position than margin constraints allow. In some cases, it is actually optimal for an investor to walk away from a pure arbitrage opportunity. Even when the optimal policy is followed, the arbitrage strategy may underperform the riskless asset or have an unimpressive Sharpe ratio. Furthermore, the arbitrage portfolio typically experiences losses at some point before the final convergence date. These results have important implications for the role of arbitrageurs in financial markets.

We conduct an empirical analysis of electricity forward prices using a high-frequency data set of hourly spot and day-ahead forward prices. We find that there are significant risk premia in electricity forward prices. These premia vary systematically throughout the day and are directly related to economic risk factors such as the volatility of unexpected changes in prices and demand as well as the risk of price spikes. In contrast to the popular post-Enron view that electricity markets are easily manipulated, these results support the hypothesis that electricity forward prices are determined rationally by risk-averse economic agents.

This dissertation focuses on a major challenge to neoclassical asset pricing theory - the existence of persistent arbitrage mispricing in financial markets. Many scholars, e.g. Liu and Longstaff (2004) and Shleifer and Vishny (2007), have challenged the neoclassical no-arbitrage paradigm. However, the nature of arbitrage mispricing is not yet fully understood and requires further study.

The first chapter 'The TIPS--Treasury Bond Puzzle', jointly written with Francis A. Longstaff and Hanno Lustig, analyzes the relative pricing between U.S. Treasury Bonds and Treasury Inflation-Protected Securities (TIPS). We document that Treasury bonds are consistently overpriced relative to TIPS. The price of a Treasury bond can exceed that of an inflation swapped TIPS issue exactly matching the cash flows of the Treasury bond by more than $20 per $100 notional amount. The relative mispricing of TIPS and Treasury bonds represents one of the largest examples of arbitrage ever documented and poses a major puzzle to classical asset pricing theory. We find direct evidence that the mispricing narrows as additional capital flows into the markets. This provides strong support for the slow-moving-capital explanation of arbitrage persistence.

In the second chapter, I extend the analysis in the first chapter to the G7 government bond markets and document new stylized facts about the dynamics and determinants of arbitrage mispricing in and across financial markets. The new insight for the slow-moving capital theory is that capital available to specific types of arbitrageurs is significantly related to the inflation-linked-nominal bond mispricing (ILB mispricing). Specifically, returns of hedge funds following fixed income strategies strongly predict subsequent changes in ILB mispricing, whereas other hedge fund categories lack statistically significant forecasting power. Furthermore, I analyze the effects of monetary policy on arbitrage mispricing and find that central banks have exacerbated mispricing through large-scale asset purchase programs.

The third chapter extends the analysis of inflation-linked securities markets. The magnitude of deflation risk and the economic and financial factors that contribute to deflation risk are not well studied. This chapter, jointly written with Francis A. Longstaff and Hanno Lustig, presents a new market-based approach for measuring deflation risk. This approach allows us to solve directly for the market's assessment of the probability of deflation for horizons of up to 30 years using the prices of inflation swaps and options. We find that the market prices the economic tail risk of deflation very similarly to other types of tail risks such as catastrophic insurance losses. In contrast, inflation tail risk has only a relatively small premium.

It is widely believed that it is optimal to call a bond as soon as its market price equals its call price. We show that this policy is generally not optimal when there is more than one bond issue outstanding because minimizing the value of a particular bond issue is not the same as maximizing the value of equity. Furthermore, the value of a callable bond can rationally exceed the call price when a firm follows the optimal call policy. These results have important implications for valuing and hedging callable bonds.

We conduct an empirical analysis of electricity forward prices using a high-frequency data set of hourly spot and day-ahead forward prices. We find that there are significant risk premia in electricity forward prices. These premia vary systematically throughout the day and are directly related to economic risk factors such as the volatility of unexpected changes in prices and demand as well as the risk of price spikes. In contrast to the popular post-Enron view that electricity markets are easily manipulated, these results support the hypothesis that electricity forward prices are determined rationally by risk-averse economic agents.