Asset Pricing Program.

• Author: Piazzesi, Monika
• Position: Program Report

The 2007-09 financial crisis challenged many long-standing beliefs about asset markets. For example, it raised questions about the applicability of the law of one price, it coincided with a period of extraordinary house price volatility, and it witnessed changing patterns of asset demand on the part of households and financial institutions alike. Over the last decade, researchers in the Asset Pricing Program have carried out a wide range of studies that are motivated by, or try to respond to, these challenges.

This report focuses on studies that exemplify post-crisis research on these three specific developments. The report is not a comprehensive review of research in the three areas, but is rather a collection of illustrative studies. Many other related papers have been distributed in the NBER Working Papers series.

Exploring Violations of the Law of One Price

The law of one price holds that two investment strategies that have exactly the same payoffs in the future should have the same value today. This principle is at the core of asset pricing theory and is usually taught at the beginning of any course in finance. Before the crisis, the law of one price was extraordinarily useful for thinking about financial markets. It was hard to come up with examples of buy-sell strategies that would generate profitable arbitrages, at least after accounting for the transaction costs that would be involved in trading based on these strategies. This suggested that violations of the law of one price did not exist, or that if they did, they were short-lived and quickly arbitraged away.

The crisis profoundly changed this situation, as the law of one price appeared to be violated in many settings. Why? The standard explanation has been weak balance sheets: Financial institutions were aware of the arbitrage opportunities but were unable to take the positions necessary to eliminate them. Some violations have persisted and are still observed today, even though balance sheets of financial institutions have recovered.

There have been particularly salient questions about price determination in foreign exchange markets. In these markets, the law of one price implies the covered interest rate parity (CIP) condition. It compares two investment strategies that do not involve risk. For example, one might be investing U.S. dollars domestically at the short-term interest rate, while the other could be investing dollars in Switzerland at the same maturity. In the latter case, the investor would exchange dollars for Swiss francs today, invest the francs at the Swiss short-term rate, and then convert them back into dollars at the current futures exchange rate. The CIP condition states that the return on these two strategies should be the same.

Wenxin Du, Alexander Tepper, and Adrien Verdelhan document that the CIP condition held up well before the crisis, but broke down afterward in the markets for G-10 currencies. (1) Figure 1, on the next page, shows these violations in basis points. For most currencies, including the Swiss franc, the Japanese yen, and the euro, it is more profitable to borrow abroad and invest domestically.

The researchers find evidence that regulatory constraints, in particular capital requirements for European banks, are responsible for the CIP violations. European banks have to hold capital against quarter-end positions. The researchers also observe stronger CIP violations toward the end of the quarter. A week from the end of the quarter, for example, European banks do not like to engage in weeklong positions. Figure 2, also on the next page, shows the pattern of the CIP deviations in forward contracts toward the end of the quarter.

Du, Joanne Im, and Jesse Schreger point to another cause for CIP violations: the attractiveness of U.S. Treasuries as safe assets for investors across the world. (2) They document large and persistent CIP violations when rates are measured from government bonds instead of LIBOR. Foreign investors appear willing to give up roughly 25 basis points per year to hold currency-hedged U.S. Treasuries as opposed to their own countries' bonds.

U.S. Treasuries are well known to be sought after as a safe asset. As a consequence, they have a convenience yield: their holders accept a lower interest rate than they could earn on other bonds because the Treasuries are more liquid than other bonds. The presence of the convenience yield leads to CIP violations even in the absence of financial frictions such as regulatory constraints, but during and after the crisis, the yield differential associated with liquidity expanded.

Zhengyang Jiang, Hanno Lustig, and Arvind Krishnamurthy argue that in times in which foreign investors assign a higher convenience yield to U.S...