Two essays on asset pricing

Abstract

This thesis centers around the pricing and risk-return tradeoff of credit and equity derivatives.

The first essay studies the pricing in the CDS Index (CDX) tranche market, and whether these instruments

have been reasonably priced and integrated within the financial market generally, both

before and during the financial crisis. We first design a procedure to value CDO tranches using

an intensity-based model which falls into the affine model class. The CDX tranche spreads are

efficiently explained by a three-factor version of this model, before and during the crisis period.

We then construct tradable CDX tranche portfolios, representing the three default intensity factors.

These portfolios capture the same exposure as the S&P 500 index optionmarket, to a market

crash. We regress these CDX factors against the underlying index, the volatility factor, and the

smirk factor, extracted from the index option returns, and against the Fama-French market, size

and book-to-market factors. We finally argue that the CDX spreads are integrated in the financial

market, and their issuers have not made excess returns.

The second essay explores the specifications of jumps for modeling stock price dynamics and

cross-sectional option prices. We exploit a long sample of about 16 years of S&P500 returns

and option prices for model estimation. We explicitly impose the time-series consistency when

jointly fitting the return and option series. We specify a separate jump intensity process which

affords a distinct source of uncertainty and persistence level from the volatility process. Our

overall conclusion is that simultaneous jumps in return and volatility are helpful in fitting the

return, volatility and jump intensity time series, while time-varying jump intensities improve the

cross-section fit of the option prices. In the formulation with time-varying jump intensity, both

the mean jump size and standard deviation of jump size premia are strengthened. Our MCMC

approach to estimate the models is appropriate, because it has been found to be powerful by

other authors, and it is suitable for dealing with jumps. To the best of our knowledge, our study

provides the the most comprehensive application of the MCMC technique to option pricing in

affine jump-diffusion models.