Bond Demand and the Yield-Exchange Rate Nexus: Risk Premium vs. Convenience Yield (JMP)

Abstract: This paper identifies two key channels through which government bond demand affects yields and exchange rates. First, higher demand reduces both bond and foreign currency risk premiums. Second, it increases the convenience yield. While both channels suppress bond yields, they have opposing effects on exchange rates. I demonstrate these mechanisms using a preferred-habitat model that features limited arbitrage and demand for liquidity. To empirically capture demand shocks, I analyze government bond auctions in advanced economies. Both a higher bid-to-cover ratio and a lower bond yield on the auction day indicate higher demand. However, a higher bid-to-cover ratio leads to domestic currency appreciation by increasing convenience yields, whereas a lower yield results in depreciation by reducing the foreign currency risk premium. These findings highlight the role of liquidity preference in the joint valuation of government bonds and exchange rates.

Speculation, Forward Exchange Demand, and CIP Deviations in Emerging Economies

(with Pierre De Leo and Lorena Keller)

Abstract: We argue that speculative forces drive the currency forward demand and shape the covered interest parity (CIP) deviations in emerging economies. We propose a model in which global investors demand forward exchange to profit from predictable currency returns, while local intermediaries, constrained by position limits, arbitrage between segmented spot and forward markets. This model explains cross-country patterns in CIP and UIP deviations, which differ from advanced economies. Using granular Peruvian data, we validate model predictions that are difficult to test with cross-country data. We find that local intermediaries' forward balances are negatively correlated with foreign customers' positions, and they consistently profit from supplying forward contracts while simultaneously hedging in the spot market. The results are robust both in the time series and across banks. Forward market prices and positions suggest that fluctuations in global investors’ forward demand also drive CIP deviations in emerging economies during periods global distress.

Common Risk Factors in the Returns on Stocks, Bonds (and Options), Redux

(with Zhongtian Chen, Nikolai Roussanov, and Xiaoliang Wang)

Abstract: Are there risk factors that are pervasive across major classes: stocks, corporate bonds, and options? We employ a novel econometric procedure that relies on asset characteristics to estimate a conditional latent factor model. A common risk factor structure prominently emerges across asset classes. Several common factors explain a substantial amount of time-series variation of individual asset returns across all three asset classes, and have sizable Sharpe ratios. Several of our factors are highly correlated with some of asset-class-specific factors as well as macroeconomic and financial variables. However, a small set of common factors does not fully capture the cross-section of average returns. A mean-variance efficient portfolio that utilizes asset characteristics achieves a high Sharpe ratio as different asset classes hedge each other's exposures to the common factors.

The A-H Premium and Implications for Global Investing in Chinese Stocks

(with Jennifer Carpenter and Robert Whitelaw)

Abstract: Among the 3,600 Chinese firms with A shares listed on the Shanghai and Shenzhen Stock Exchanges, about 100 have H shares dual-listed on the Hong Kong Stock Exchange. The prices of the A shares have historically exceeded those of H shares by 60% or more on average. Why do Chinese investors price these stocks so much higher than global investors in Hong Kong? Does this imply that global investors seeking to invest in Chinese firms should prefer foreign-listed stocks over domestic-listed stocks more generally? This paper analyzes the cross-sectional and time series determinants of the A-H premium. We find that traditional asset pricing factors have significant explanatory power, but our results suggest that additional factors such as barriers to convergence and home bias also play an important role. Market-level analysis shows that the A-H premium does not imply that H shares are the better investment for global investors once portfolio considerations are taken into account, because H-share returns are much more highly correlated with the global stock market than A shares.

Passive Investing and Stock-Specific Price Informativeness: The Lendable Supply Channel

Abstract: This paper documents a positive association between passive fund ownership and stock- specific price informativeness. The paper proposes that passive funds improve stock-specific price efficiency by expanding the stock’s lendable supply and thereby alleviating the short- selling constraints, namely the “lendable supply” channel. Aligned with the lendable supply channel, the positive association only shows up within short-selling constrained stocks and is largely absorbed by the lendable supply. Using the Russell 1000/2000 index assignment as an instrument for passive fund ownership, the positive relation is causal, and a 1% increase in passive ownership leads to at least a 0.7% increase in lendable supply. In the quantification exercise, almost all of the positive effect can be explained by the lendable supply channel.