Essays in financial economics and econometrics

My dissertation consists of three essays, which cover topics in theoretical and empirical finance. In the first essay titled “the skewness premium and the asymmetric volatility puzzle,” we use a general equilibrium model to study the source and reward of asymmetric volatility or skewness of market returns in an exchange economy. It is shown that the equity premium has a component due to the negative skewness risk. The essay then studies the skewness premium and asymmetric volatility under various values of the risk aversion coefficient and elasticity of intertemporal substitution. It is shown that the skewness premium can be as high as 1.2% annually in real terms. However, under conventional levels of risk aversion and elasticity of intertemporal substitution, the asymmetric volatility generated by the model is much smaller than that observed in the data and hence results in the asymmetric volatility puzzle. In the second essay titled “option pricing in regime-switching environments,” we consider a regime-switching model in which volatility, skewness and kurtosis are allowed to vary across regimes and investigate option prices in this stochastic environment. We derive a simple closed-form European option pricing formula that does not rely on simulation or numerical integration and estimate a two-regime specification using S&P 500 options data over 1992–1994. Consistent with other studies of stock market volatilities, we find a low persistent volatility regime, and a less persistent high volatility regime. We also find, however, that the high volatility regime is also characterized by significant negative skewness. In my last essay, “modeling and forecasting the term structure of government bond yields,” we use variations on the Nelson-Siegel exponential components framework to model the entire yield curve, as a three-dimensional parameter evolving dynamically. We show that the three time-varying parameters may be interpreted as factors corresponding to level, slope and curvature, and that they may be estimated with high efficiency. We propose and estimate autoregressive models for the factors, and we show that our models are consistent with a variety of stylized facts regarding the yield curve. We use our models to produce term-structure forecasts at both short and long horizons, with encouraging results