Estimating the Term Structure of Yield Spreads from Callable Corporate Bond Price Data

I extract credit pricing information from the prices of callable corporate debt, by disentangling the components of callable corporate bond prices associated with discounting at market interest rates, discounting for default risk, and optionality. The results include the first empirical analysis, in the setting of standard arbitrage-free term-structure models, of the time-series behavior of callable corporate bond yield spreads, explicitly incorporating the valuation of the American call options. As an application, I consider medium-quality callable issues of Occidental Petroleum Corporation, using a three-factor model for the term structures of benchmark LIBOR-dollar swap rates and for Occidental yield spreads.

Specification Analysis of Reduced-Form Credit Risk Models

This paper employs non-parametric specification tests developed in Hong and Li (2005) to evaluate several one-factor reduced-form credit risk models for actual default intensities. Using estimates for actual default probabilities provided by Moody’s KMV from 1994 to 2005 for 106 U.S. firms in seven industry groups, we strongly reject popular univariate affine model specifications. As a good compromise between goodness-of-fit and model simplicity we propose to assume that the logarithm of the actual default intensity follows an Ornstein-Uhlenbeck process, also known as the Black-Karasinski (BK) model. For the BK model specification, we find that there is substantial mean-reversion in actual log-default intensities, with an average half-time of roughly 18 months. Our results also show that the level of pairwise correlation in log-default intensities differs across industries. It is higher among oil and gas companies, and lower for healthcare firms.

The pricing of risk in European credit and corporate bond markets

This paper investigates the determinants of the default risk premia embedded in the European credit default swap spreads. Using a modified version of the intertemporal capital asset pricing model, we show that default risk premia represent compensation for bearing exposure to systematic risk and to a new common factor capturing the proneness of the asset returns to extreme events. This new factor arises naturally because the returns on defaultable securities are more likely to have fat tails. The pricing implications of this new factor are not limited to credit markets only. We find that this common factor is priced consistently across a broad spectrum of corporate bond portfolios. In addition, our asset pricing tests also document patterns that are consistent with the so called "flight to quality" effect. JEL Classification: G12, G13, G15credit default swap, default risk premium, European corporate bond markets, European credit market, risk factors

Decomposing the Returns on European Debt

Common variation in the prices of European corporate debt may not always be associated with a rational response to an increase in the relative importance of a macroeconomic risk factor. Building on Campbell’s ICAPM framework, we show that risk premia of assets with nonlognormal return distributions represent compensation not only for exposure to macroeconomic factors but also for unexpected revisions to these assets’ return distributions, such as sudden increases in the likelihood of extreme events. If such revisions happen across assets almost simultaneously, perhaps as a systemic response to a large credit event, they can induce covariation in risk premia unrelated to the time variation of the priced macroeconomic factors. Our study presents evidence from the European debt markets which supports this theory. The asset pricing tests also document patterns consistent with the “flight to quality” effect for European corporate bonds.

Do Equity Markets Favor Credit Market News Over Options Market News?

Both credit default swap (CDS) and options markets often experience abnormal swings prior to the announcement of negative credit news. With the exclusion of negative earnings announcements, we find that options prices reveal information about such forthcoming adverse events at least as early as do credit spreads. Prior to negative credit news being publicly disclosed, we find that the equity market does not respond to abnormal movement in options prices unless that information has also manifested itself in the CDS market. A potential explanation is that options are more likely to trade on unsubstantiated rumors than are default swaps.

On Correlation Effects and Default Clustering in Credit Models

We establish Markovian models in the Heath, Jarrow and Morton paradigm where the credit spreads curves of multiple firms and the term structure of interest rates can be represented analytically at any point in time in terms of a finite number of state variables. The models make no restrictions on the correlation structure between interest rates and credit spreads. In addition to diffusive and jump-induced default correlations, default events can impact credit spreads of surviving firms. This feature allows a greater clustering of defaults. Numerical implementations highlight the importance of taking interest rate-credit spread correlations, credit-spread impact factors and the full credit spread curve information into account when building a unified model framework that prices any credit derivative.

How does the U.S. government finance fiscal shocks?

We develop a method for identifying and quantifying the fiscal channels that help finance government spending shocks. We define fiscal shocks as surprises in defense spending and show that they are more precisely identified when defense stock data are used in addition to aggregate macroeconomic data. Our results show that in the postwar period, about 9% of the U.S. government’s unantic- ipated spending needs were financed by a reduction in the market value of debt and more than 70% by an increase in primary sur- pluses. Additionally, we find that long-term debt is more effective at absorbing fiscal risk than short-term debt.

What Broker Charges Reveal about Mortgage Credit Risk previously entitled "The Role of Mortgage Brokers in the Subprime Crisis"

Prior to the subprime crisis, mortgage brokers charged higher percentage fees for loans that turned out to be riskier ex post, even when conditioning on other risk characteristics. High conditional fees reveal borrower attributes that are associated with high borrower risk, such as suboptimal shopping behavior, high valuation for the loan or high borrower-specific broker costs. Borrowers who pay high conditional fees are inherently more risky, not just because they pay high fees. We find a stronger association between conditional fees and delinquency risk when lenders have fewer incentives to screen borrowers, for purchase rather than refinance loans, and for loans originated by brokers who have less frequent interactions with the lender. Our findings shed light on the proposed QRM exemption criteria for risk retention requirements for residential mortgage securitizations.

Default Risk Premia and Asset Returns

We identify a common default risk premia (DRP) factor in the risk-adjusted excess returns on pure default-contingent claims. Asset pricing tests using almost 50 corporate bond portfolios sorted on rating, maturity or industry suggest that the DRP factor is priced in the corporate bond market. For index put option portfolios sorted on maturity and moneyness, both average returns and DRP beta estimates become more negative with decreasing time to maturity. There is little to no evidence of the DRP factor being priced in equity markets. Most of the variation in DRP is explained by the portion DRP^{JtD} due to common jump-to-default risk premia. A theoretical framework where DRP^{JtD} is part of the pricing kernel supports our empirical findings.

Restructuring Risk in Credit Default Swaps: An Empirical Analysis

This paper estimates the price for restructuring risk in the U.S. corporate bond market during 1999-2005. Comparing quotes from default swap (CDS) contracts with a restructuring event and without, we find that the average premium for restructuring risk represents 6% to 8% of the swap rate without restructuring. We show that the restructuring premium depends on firm-specific balance-sheet and macroeconomic variables. And, when default swap rates without a restructuring event increase, the increase in restructuring premia is higher for low-credit-quality firms than for high-credit-quality firms. We propose a reduced-form arbitrage-free model for pricing default swaps that explicitly incorporates the distinction between restructuring and default events. A case study illustrating the model's implementation is provided.