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Speaker : Dong-Hyun Ahn/President Seoul National University Korea Capital Market Institute

Abstract:

We extend the limited arbitrage model of Shleifer and Vishny (1997) to an intertem-poral model while simplifying a funding cost structure. The model implies that the equilibrium price is more volatile during a crash than during a tranquil market period. More importantly, a seemingly more efficient market is more vulnerable to a crash and shows more extreme tail volatility and a larger difference between tail volatility and non-tail volatility. We empirically examine such implications in a U.S. interest rate swap market. The mean-reversion speeds of slope and butterfly spreads between swap yields are strongly associated with tail behavior of those spreads, which is in compliance with our model.