Essays on empirical asset pricing

Abstract

This thesis focuses on empirical asset pricing, and it contains the following three essays:The first essay derives a U.S. government bond market volatility index (GBVX) based on the Arrow-Debreu state-contingent pricing methodology. We show that GBVX is an unbiased predictor for the next 30-day realized volatility of the Treasury note futures return. GBVX also subsumes the information of GARCH, EWMA and historical volatility measures. Furthermore, GBVX serves as an effective predictor for the future realized volatilities of a wide class of fixed income portfolios. The results suggest GBVX served as a powerful instrument for volatility forecasting in the fixed income markets.The second essay shows that the innovation in GBVX delivers statistically and economically significant in-sample and out-of-sample predictive power for U.S. equity risk premium over the recent 2000-2015 sample period. It yields a sizable increase in terminal wealth growth, Sharpe ratio, and utility gains. In addition, the predictive ability of the innovation in GBVX is comparable to, and in a majority of cases, surpasses those of conventional predictors commonly used in the literature, as well as a range of historical and other implied volatility indices. The strong predictive ability of the innovation in GBVX stems from its anticipation of cash flow news.In the third essay, we test the hypothesis that liquidity and pricing efficiency causally affect each other. As a response to the 2015 Chinese stock market crash, regulators prohibited arbitrage activities in the index futures and cash markets. Based on this natural experiment, we find that the absence of arbitrage activities led to the breakdown of the two-way causality relation between liquidity and the absolute futures-cash basis. We thus confirm that the relation between liquidity and the absolute futures-cash basis is not driven by the omitted variable bias, but is indeed due to arbitrage.iii Declaration by AuthorThis thesis is composed of my original work, and contains no material previously published or written by another person except where due reference has been made in the text. I have clearly stated the contribution by others to jointly-authored works that I have included in my thesis.