Common Failings: How Corporate Defaults are Correlated

We develop, and apply to data on U.S. corporations from 1979-2004, tests of the standard doubly-stochastic assumption under which firms'default times are correlated only as implied by the correlation of factors determining their default intensities. This assumption is violated in the presence of contagion or "frailty" (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time-series properties of default intensities. The data do not support the joint hypothesis of well specified default intensities and the doubly-stochastic assumption. There is also some evidence of default clustering in excess of that implied by the doubly-stochastic model with the given intensities.

Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options

This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the risk-neutral density. Third, we derive laws that decompose individual return skewness into a systematic component and an idiosyncratic component. Empirical analysis of OEX options and 30 stocks demonstrates that individual riskneutral distributions differ from that of the market index by being far less negatively skewed. This article explains the presence and evolution of risk-neutral skewness over time and in the cross section of individual stocks. Skewness continues to occupy a prominent role in equity markets. In the traditional asset pricing literature, stocks with negative coskewness command a higher equilibrium risk compensation [see Rubinstein (1973), and the empirical applications in Kraus and Litzenberger (1976) and Harvey and Siddique (2000)]. Realizing the inherent importance of skewness, Merton (1976), Rubinstein (1994), Bakshi, Cao, and Chen (1997), Ait-Sahalia and Lo (1998), Madan, Carr, and Chang (1998), Pan (1999), Bates (2000), and We acknowledge discussions on this topic with Yacine Ait-Sahalia, Torben Anderson, Meghana Ayyagari, Warren Bailey, Ravi Bansal, David Bates, Nick Bollen, Peter Carr, Charles Cao, Henry Cao, Zhiwu Chen, George Chacko, Amy Chan, Dave Chapman, Alex David, Darrell Duffie, Rob Engle, Rene Garcia, Eric Ghysels, John Guo, Levent Guntay, Hua He, Mike Hemler, Harrison Hong, Ming Huang, Jon Ingersoll, Bob Jarrow, Nengjiu Ju, Hossein Kazemi, Inanc Kirgiz, Haitao Li, Nour Meddahi, Maureen O'Hara, Jun Pan, Gurupdesh Pande, Nagpurnanand Prabhala, Chandrase..

Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options

This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index, and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the risk-neutral density. Third, we derive laws that decompose individual return skewness into a systematic component and an idiosyncratic component. Empirical analysis of OEX options and 30 stocks demonstrates that individual risk-neutral distributions differ from that of the market index by being far less negatively skewed. This paper explains the presence and evolution of risk-neutral skewness over time and in the cross-section of individual stocks

Understanding the Role of VIX in Explaining Movements in Credit Spreads

Why does the VIX and market return explain changes in credit spreads? Existing literature suggests these factors proxy for macroeconomic risk. In this paper, we investigate an alternative hypothesis that the VIX in its role as a fear index impacts intermediary and arbitrageur capital, impacting spreads and resulting in decreased market integration across credit and equity markets. We document that hedging credit default swaps in the equity markets is surprisingly ineffective. On average, hedging reduces the RMSE reduces by 10% and the VaR by only 12%. However, a passive hedge kept in place over a period as long as a month is (multifold) more effective than dynamic daily hedging. We demonstrate that the VIX and market returns predict both the RMSE as well as the improvement in hedging effectiveness that occurs over time. Our results suggest that frictionless structural models of credit risk are of limited use in explaining changes in credit spreads because factors which are excluded from the pricing kernel have significant impact on credit spreads