Essays on Empirical Asset Pricing

My dissertation aims at understanding the dynamics of asset prices empirically. It contains three chapters. Chapter One provides an estimator for the conditional expectation function using a partially misspecified model. The estimator automatically detects the dimensions along which the model quality is good (poor). The estimator is always consistent, and its rate of convergence improves toward the parametric rate as the model quality improves. These properties are confirmed by both simulation and empirical application. Application to the pricing of Treasury options suggests that the cheapest-to-deliver practice is an important source of misspecification. Chapter Two examines the informational content of credit default swap (CDS) net notional for future stock and CDS prices. Using the information on CDS contracts registered in DTCC, a clearinghouse, I construct CDS-to-debt ratios from net notional, that is, the sum of net positive positions of all market participants, and total outstanding debt issued by the reference entity. Unlike the ratio using the sum of all outstanding CDS contracts, this ratio directly indicates how much of debt is insured with CDS and therefore, is a natural measure of investors concern on a credit event of the reference entity. Empirically, I find cross-sectional evidence that the current increase in CDS to- debt ratios can predict a decrease in stock prices and an increase in CDS premia of the reference firms in the next week. Greater predictability for firms with investment grade credit ratings or low CDS-to debt ratios suggests that investors pay more attention to firms in good credit conditions than those regarded as junk or already insured considerably with CDS. Chapter Three tests the relationship between credit default swap net notional and put option prices. Given motivation that both CDS and put options are used not only as a type of insurance but also for negative side bets, both contemporaneous and predictive analysis are performed for put option returns and changes in implied volatilities with time-to-maturities of 1, 3, and 6 months. The results show that there is no empirical evidence that CDS net notional and put option prices are closely connected

Feats and Failures of Corporate Credit Risk, Stock Returns, and the Interdependencies of Sovereign Credit Risk

This dissertation comprises two essays; the first of which investigates sovereign credit risk interdependencies, while the second examines the reaction of corporate credit risk to sovereign credit risk events. The first essay titled, Characterizing Sovereign Credit Risk Interdependencies: Evidence from the Credit Default Swap Market, investigates the relationships that exist among disparate sovereign credit default swaps (CDS) and the implications on sovereign creditworthiness. We exploit emerging market sovereign CDS spreads to examine the reaction of sovereign credit risk to changes in country-specific and global financial factors. Utilizing aVAR model fitted with DCC GARCH, we find that comovements of spreads generally exhibit significant time-varying correlations, suggesting that spreads are commonly affected by global financial factors. We construct 19 country-specific commodity price indexes to instrument for country terms of trade, obtaining significant results. Our commodity price indexes account for significant variation in CDS spreads, controlling for global financial factors. In addition, sovereign spreads are found to be related to U.S. stock market returns and the VIX volatility risk premium global factors. Notwithstanding, our results suggest that terms of trade and commodity prices have a statistically and economically significant effect on the sovereign credit risk of emerging economies. Our results apply broadly to investors, financial institutions and policy makers motivated to utilize profitable factors in global portfolios. The second essay is titled, Differential Stock Market Returns and Corporate Credit Risk of Listed Firms. This essay explores the information transfer effect of shocks to sovereign credit risk as captured in the CDS and stock market returns of cross-listed and local stock exchange listed firms. Based on changes in sovereign credit ratings and outlooks, we find that widening CDS spreads of firms imply that negative credit events dominate, whereas tightening spreads indicate positive events. Grouping firms into companies with cross-listings and those without, we compare the spillover effects and find strong evidence of contagion across equity and CDS markets in both company groupings. Our findings suggest that the sensitivity of corporate CDS prices to sovereign credit events is significantly larger for non-cross-listed firms. Possible reasons for this finding could in fact be due to cross-listed firms’ better access to external capital and less degree of asymmetric information, relative to non-cross-listed peers with lower level of investor recognition. Our results provide new evidence relevant to investors and financial institutions in determining sovereign credit risk germane to corporate financial risk, for the construction of debt and equity portfolios, and hedging considerations in today’s dynamic environment

Mechanically Extracted Company Signals and their Impact on Stock and Credit Markets

I analyze company news from Reuters with the 'General Inquirer' and relate measures of positive sentiment, negative sentiment and disagreement to abnormal stock returns, stock and option trading volume, the volatility spread and the CDS spread. I test hypotheses derived from market microstructure models. Consistent with these models, sentiment and disagreement are strongly related to trading volume. Moreover, sentiment and disagreement might be used to predict stock returns, trading volume and volatility. Trading strategies based on positive and negative sentiment are profitable if the transaction costs are moderate, indicating that stock markets are not fully efficient.Content Analysis, Company News, Market Microstructure

The 2011 European short sale ban on financial stocks: a cure or a curse? : [version 31 july 2013]

Did the August 2011 European short sale bans on financial stocks accomplish their goals? In order to answer this question, we use stock options’ implied volatility skews to proxy for investors’ risk aversion. We find that on ban announcement day, risk aversion levels rose for all stocks but more so for the banned financial stocks. The banned stocks’ volatility skews remained elevated during the ban but dropped for the other unbanned stocks. We show that it is the imposition of the ban itself that led to the increase in risk aversion rather than other causes such as information flow, options trading volumes, or stock specific factors. Substitution effects were minimal, as banned stocks’ put trading volumes and put-call ratios declined during the ban. We argue that although the ban succeeded in curbing further selling pressure on financial stocks by redirecting trading activity towards index options, this result came at the cost of increased risk aversion and some degree of market failure

The role of investment banking for the German economy: Final report for Deutsche Bank AG, Frankfurt/Main

The aim of this study is to assess the contributions of investment banking to the economy with a particular focus on the German economy. To this end we analyse both the economic benefits and the costs stemming from investment banking. The study focuses on investment banks as this part of banking is particularly relevant for financing companies as well as the development and use of specific products to support the needs of private and professional clients. The assessment of benefits and costs of investment banking has been conducted from a European perspective. Nevertheless there is a focus on the German economy to allow a more detailed analysis of certain aspects as for example the use of derivatives by German companies, the success of M&As in Germany or the effect of securitization on loan supply and GDP in Germany. For comparison purposes other European countries and also the U.S. have been taken into account. The last financial crisis has shown the negative impacts of banks on the financial system and the whole economy. In a study on the contribution of investment banks to systemic risk we quantify the negative side of the investment banking business. In the last part of the study we assess how the effects of regulatory changes on investment banking. All important changes in banking and capital market regulation are taken into account such as Basel III, additional capital requirements for systemically important financial institutions, regulation of OTC derivatives and specific taxes. --

The Management of Greek Sovereign Risk

In 2010 the excessive public spending produced the first sovereign bond market crisis in Europe: Greece. The Hellenic crisis is the product of years of recession, of the sluggish economic environment and poor productivity – but above all it is the product of the mismanagement of the public finance, of unsatisfactory reporting, risk management and accounting practices. Information about Greece is scarce and fragmented, but the inability by European authorities to understand the incredible mismanagement strongly disappoints the taxpayer. The relevant exposure of European banks in the bond market toward the default risk of Greece supports the need for hedging tools, such as Credit Default Swaps. However, there is evidence that the CDS market on Greek sovereign bonds is segmented, and contracts are mis-priced. The lack of comprehensive data on CDS and other OTC contracts impedes any further investigation. European authorities should consider revising CDSs trading rules and requirements, until the risks produced are properly limitedGreek crisis, Credit Default Swap, sovereign risk management

Too Interconnected To Fail: Financial Contagion and Systemic Risk in Network Model of CDS and Other Credit Enhancement Obligations of US Banks

Credit default swaps (CDS) which constitute up to 98% of credit derivatives have had a unique, endemic and pernicious role to play in the current financial crisis. However, there are few in depth empirical studies of the financial network interconnections among banks and between banks and nonbanks involved as CDS protection buyers and protection sellers. The ongoing problems related to technical insolvency of US commercial banks is not just confined to the so called legacy/toxic RMBS assets on balance sheets but also because of their credit risk exposures from SPVs (Special Purpose Vehicles) and the CDS markets. The dominance of a few big players in the chains of insurance and reinsurance for CDS credit risk mitigation for banks� assets has led to the idea of �too interconnected to fail� resulting, as in the case of AIG, of having to maintain the fiction of non-failure in order to avert a credit event that can bring down the CDS pyramid and the financial system. This paper also includes a brief discussion of the complex system Agent-based Computational Economics (ACE) approach to financial network modeling for systemic risk assessment. Quantitative analysis is confined to the empirical reconstruction of the US CDS network based on the FDIC Q4 2008 data in order to conduct a series of stress tests that investigate the consequences of the fact that top 5 US banks account for 92% of the US bank activity in the $34 tn global gross notional value of CDS for Q4 2008 (see, BIS and DTCC). The May-Wigner stability condition for networks is considered for the hub like dominance of a few financial entities in the US CDS structures to understand the lack of robustness. We provide a Systemic Risk Ratio and an implementation of concentration risk in CDS settlement for major US banks in terms of the loss of aggregate core capital. We also compare our stress test results with those provided by SCAP (Supervisory Capital Assessment Program). Finally, in the context of the Basel II credit risk transfer and synthetic securitization framework, there is little evidence that the CDS market predicated on a system of offsets to minimize final settlement can provide the credit risk mitigation sought by banks for reference assets in the case of a significant credit event. The large negative externalities that arise from a lack of robustness of the CDS financial network from the demise of a big CDS seller undermines the justification in Basel II that banks be permitted to reduce capital on assets that have CDS guarantees. We recommend that the Basel II provision for capital reduction on bank assets that have CDS cover should be discontinued.

Too Interconnected To Fail: Financial Contagion and Systemic Risk In Network Model of CDS and Other Credit Enhancement Obligations of US Banks

Credit default swaps (CDS) which constitute up to 98% of credit derivatives have had a unique, endemic and pernicious role to play in the current financial crisis. However, there are few in depth empirical studies of the financial network interconnections among banks and between banks and nonbanks involved as CDS protection buyers and protection sellers. The ongoing problems related to technical insolvency of US commercial banks is not just confined to the so called legacy/toxic RMBS assets on balance sheets but also because of their credit risk exposures from SPVs (Special Purpose Vehicles) and the CDS markets. The dominance of a few big players in the chains of insurance and reinsurance for CDS credit risk mitigation for banks’ assets has led to the idea of “too interconnected to fail” resulting, as in the case of AIG, of having to maintain the fiction of non-failure in order to avert a credit event that can bring down the CDS pyramid and the financial system. This paper also includes a brief discussion of the complex system Agent-based Computational Economics (ACE) approach to financial network modeling for systemic risk assessment. Quantitative analysis is confined to the empirical reconstruction of the US CDS network based on the FDIC Q4 2008 data in order to conduct a series of stress tests that investigate the consequences of the fact that top 5 US banks account for 92% of the US bank activity in the $34 tn global gross notional value of CDS for Q4 2008 (see, BIS and DTCC). The May-Wigner stability condition for networks is considered for the hub like dominance of a few financial entities in the US CDS structures to understand the lack of robustness. We provide a Systemic Risk Ratio and an implementation of concentration risk in CDS settlement for major US banks in terms of the loss of aggregate core capital. We also compare our stress test results with those provided by SCAP (Supervisory Capital Assessment Program). Finally, in the context of the Basel II credit risk transfer and synthetic securitization framework, there is little evidence that the CDS market predicated on a system of offsets to minimize final settlement can provide the credit risk mitigation sought by banks for reference assets in the case of a significant credit event. The large negative externalities that arise from a lack of robustness of the CDS financial network from the demise of a big CDS seller undermines the justification in Basel II that banks be permitted to reduce capital on assets that have CDS guarantees. We recommend that the Basel II provision for capital reduction on bank assets that have CDS cover should be discontinued.Credit Default Swaps; Financial Networks; Systemic Risk; Agent BasedCredit Default Swaps, Financial Networks, Systemic Risk, Agent Based Models, Complex Systems, Stress Testing

“Does the tail wag the dog? The effect of credit default swaps on credit risk”

Credit default swaps (CDS) are derivative contracts that are widely used as tools for credit risk management. However, in recent years, concerns have been raised about whether CDS trading itself affects the credit risk of the reference entities. We use a unique, comprehensive sample covering CDS trading of 901 North American corporate issuers, between June 1997 and April 2009, to address this question. We find that the probability of both a credit rating downgrade and bankruptcy increase, with large economic magnitudes, after the inception of CDS trading. This finding is robust to controlling for the endogeneity of CDS trading. Beyond the CDS introduction effect, we show that firms with relatively larger amounts of CDS contracts outstanding, and those with relatively more “no restructuring” contracts than other types of CDS contracts covering restructuring, are more adversely affected by CDS trading. Moreover, the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure for the resolution of financial distress

Trading the bond-CDS basis: The role of credit risk and liquidity

We analyze trading opportunities that arise from differences between the bond and the CDS market. By simultaneously entering a position in a CDS contract and the underlying bond, traders can build a default-risk free position that allows them to repeatedly earn the difference between the bond asset swap spread and the CDS, known as the basis. We show that the basis size is closely related to measures of company-specific credit risk and liquidity, and to market conditions. In analyzing the aggregate profits of these basis trading strategies, we document that dissolving a position leads to significant profit variations, but that attractive risk-return characteristics still apply. The aggregate profits depend on the credit risk, liquidity, and market measures even more strongly than the basis itself, and we show which conditions make long and short basis trades more profitable. Finally, we document the impact of the financial crisis on the profits of long and short basis trades, and show that the formerly more profitable long basis trades experienced stronger profit decreases than short basis trades. --bond asset swap spreads,CDS premia,basis trading profits,credit risk,liquidity,fixed-effects,vector error correction model