Group Affiliation and the Performance of Initial Public Offerings in the Indian Stock Market

We document the effects of group affiliation on the initial performance of 2,713 Initial Public Offerings (IPOs) in India under three regulatory regimes during the period 1990-2004. We distinguish between two competing hypotheses regarding group affiliation: the “certification” and the “tunneling” hypotheses. We lend support to the latter by showing that the underpricing of business group companies is higher than that of stand-alone companies. Furthermore, we find that the long run performance of IPOs, in general, is negative. We also find that Indian investors over-react to IPOs and their over-reaction (proxied by the oversubscription rate) explains the extent of underpricing

Incremental Risk Vulnerability

We present a necessary and sufficient condition on an agent’s utility function for a simple mean preserving spread in an independent background risk to increase the agent’s risk aversion (incremental risk vulnerability). Gollier and Pratt (1996) have shown that declining and convex risk aversion as well as standard risk aversion are sufficient for risk vulnerability. We show that these conditions are also sufficient for incremental risk vulnerability. In addition, we present sufficient conditions for a restricted set of stochastic increases in an independent background risk to increase risk aversion.

An Examination of the Static and Dynamic Performance of Interest Rate Option Pricing Models In the Dollar Cap-Floor Markets

This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models of the spot and the forward interest rates on the basis of their out-of-sample predictive ability in terms of pricing and hedging performance. The one-factor models analyzed consist of two spot-rate specifications (Hull and White (1990) and Black-Karasinski (1991), five forward rate specifications (within the general Heath, Jarrow and Morton (1990b) class), and one LIBOR market model (Brace, Gatarek and Musiela (1997) [BGM]). For two-factor models, two alternative forward rate specifications are implemented within the HJM framework. We conduct tests on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Overall, the one-factor lognormal model for short term interest rates outperforms other competing models in pricing tests, while two-factor models perform significantly better than one-factor models in hedging tests. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus, the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims

“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

The Term Structure of Interest-Rate Future Prices

We derive general properties of two-factor models of the term structure of interest rates and, in particular, the process for futures prices and rates. Then, as a special case, we derive a no-arbitrage model of the term structure in which any two futures rates act as factors. The term structure shifts and tilts as the factor rates vary. The cross-sectional properties of the model derive from the solution of a two-dimensional autoregressive process for the short-term rate, which exhibits both mean reversion and a lagged persistence parameter. We show that the correlation of the futures rates is restricted by the no-arbitrage conditions of the model. In addition, we investigate the determinants of the volatility of the futures rates of various maturities. These are shown to be related to the volatilities of the short rate, the volatility of the second factor, the degree of mean reversion and the persistence of the second factor shock. We obtain specific results for futures rates in the case where the logarithm of the short-term rate [e.g., the London Inter-Bank Offer Rate (Libor)] follows a two-dimensional process. Our results lead to empirical hypotheses that are testable using data from the liquid market for Eurocurrency interest rate futures contracts

Securitization and Real Investment in Incomplete Markets

We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of fi rms, investors, and an intermediary. The fi rms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the fi nancial market, and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors. We derive necessary and suffcient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments, synergies among them, and their fi nancing mechanisms. We illustrate these implications using an example of inventory decisions under random demand

Illiquidity or Credit Deterioration: A Study of Liquidity in the US Corporate Bond Market during Financial Crises

We use a unique data-set to study liquidity effects in the US corporate bond market, covering more than 30,000 bonds. Our analysis explores time-series and cross-sectional aspects of corporate bond yield spreads, with the main focus being on the quanti fication of the impact of liquidity factors, while controlling for credit risk. Our time period starts in October 2004 when detailed transaction data from the Trade Reporting and Compliance Engine (TRACE) became available. In particular, we examine three diff erent regimes during our sample period, the GM/Ford crisis in 2005 when a segment of the corporate bond market was a ffected, the sub-prime crisis since mid-2007, which was much more pervasive across the corporate bond market, and the period in between, when market conditions were more normal. We employ a wide range of liquidity measures and fi nd in our time-series analysis that liquidity eff ects explain approximately one third of market-wide corporate yield spread changes, in general, and are even more pronounced during periods of crisis. In particular, the price dispersion measure proposed by Jankowitsch, Nashikkar and Subrahmanyam (2008) explains about half of the aggregate bond yield spread changes during the sub-prime crisis. Our data-set allows us to examine in greater detail liquidity e ffects in various segments of the market: financial sector fi rms which have been particularly aff ected by the crisis vs. industrial firms, investment grade vs. speculative grade bonds, and retail vs. institutional trades. In addition, our cross-sectional analysis shows that liquidity explains a large part of the variation in yield spreads across bonds, after accounting for credit risk. These results yield important insights regarding the liquidity drivers of corporate yield spreads, particularly during periods of crisis

GROUP AFFILIATION AND THE PERFORMANCE OF INITIAL PUBLIC OFFERINGS IN THE INDIAN STOCK MARKET

We document the effects of group affiliation on the initial performance of 2,713 Initial Public Offerings (IPOs) in India under three regulatory regimes during the period 1990-2004. We distinguish between two competing hypotheses regarding group affiliation: the “certification” and the “tunneling” hypotheses. We lend support to the latter by showing that the underpricing of group companies is higher than that of stand-alone companies. We ascribe the higher initial returns of group IPOs to investor overreaction. Ex post, we find that group-affiliated companies have a higher probability of survival over the long term: groups support their affiliates to maintain their reputation

Illiquidity or credit deterioration: A study of liquidity in the US corporate bond market during

We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity eects are more pronounced in periods of nancial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and nd that liquidity eects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is signicantly larger in periods of crisis, and for speculative grade bonds

Intermediation and Value Creation in an Incomplete Market: Implications for Securitization

This paper studies the impact of financial innovations on real investment decisions. We model an incomplete market economy comprised of firms, investors and an intermediary. The firms face unique investment opportunities that are not spanned by the traded securities in the financial market, and thus, cannot be priced uniquely using the no-arbitrage principle. The specific innovation we consider is securitization; the intermediary buys claims from the firms that are fully backed by cash flows from the new projects, pools these claims together, and then issues tranches of secondary securities to the investors. We first derive necessary and sufficient conditions under which pooling provides value enhancement and the prices paid to the firms are acceptable to them compared to the no-investment option or the option of forming alternative pools. We find that there is a unique pool that is sustainable, and may or may not consist of all projects in the intermediary’s consideration set. We then determine the optimal design of tranches, fully backed by the asset pool, to be sold to different investor classes. We determine the general structure of the tranches. The new securities created by the intermediary could have up to three components, one that is a marketable claim, one that represents the arbitrage opportunities available in the market due to special ability to design and sell securities to a subset of investors, and a third component that is the rest of the asset pool which is sold at a price which does not exceed arbitrage based bounds to investors. The presence of these three components in the tranching solution has direct bearing upon the size of the asset pool, and therefore value creation due to financing additional projects