Using dealer’s quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross-correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply0 demand shocks that are independent of both credit-risk factors and standard proxies for liquidity.

This paper presents a dynamic asset-pricing model under asymmetric information. Investors have different information concerning the future growth rate of dividends. They rationally extract information from prices as well as dividends and maximize their expected utility. The model has a closed-form solution to the rational expectations equilibrium. We find that existence of uninformed investors increases the risk premium. Supply shocks can affect the risk premium only under asymmetric information. Information asymmetry among investors can increase price volatility and negative autocorrelation in returns. Less-informed investors may rztionally behave like price chasers.

Previous research has shown that under a suitable no-jump condition, the price of a defaultable security is equal to its risk-neutral expected discounted cash flows if a modified discount rate is introduced to account for the possibility of default. Below, we generalize this result by demonstrating that one can always value defaultable claims using expected risk-adjusted discounting provided that the expectation is taken under a slightly modified probability measure. This new probability measure puts zero probability on paths where default occurs prior to the maturity, and is thus only absolutely continuous with respect to the risk-neutral probability measure. After establishing the general result and discussing its relation with the existing literature, we investigate several examples for which the no-jump condition fails. Each example illustrates the power of our general formula by providing simple analytic solutions for the prices of defaultable securities.

We introduce and discuss a general criterion for the derivative pricing in the general situation of incomplete markets, we refer to it as the No Almost Sure Arbitrage Principle. This approach is based on the theory of optimal strategy in repeated multiplicative games originally introduced by Kelly. As particular cases we obtain the Cox-Ross-Rubinstein and Black-Scholes in the complete markets case and the Schweizer and Bouchaud-Sornette as a quadratic approximation of our prescription. Technical and numerical aspects for the practical option pricing, as large deviation theory approximation and Monte Carlo computation are discussed in detail. 1.

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We consider an economy with an incomplete securities market and heterogeneously informed investors. Each investor trades in the market to hedge the risk to his endowment and to speculate on future security payoffs using his private information. We examine the efficiency of the securities market in allocating risk and transmitting information under different market structures, as defined by the set of securities traded in the market. We show that the introduction of derivative securities can decrease the market’s efficiency in revealing information on security payoffs, and increase the equity premium and price volatility in the market.

In recent years results from the theory of martingales has been successfully applied to problems in financial economics. In the present paper we show how efficient and elegant this "martingale technology" can be when solving for complex options. In particular we provide closed form solutions for several new classes of exotic options including the cliquet, the ladder, the discrete shout and the discrete lookback. We also provide a derivation of the price of an option on the maximum of n assets to demonstrate the power of the multi-dimensional Girsanov theorem. Although some of the results presented are well known, the treatment of the material in this paper is new in that it focuses on the application of the martingale technology to concrete problems in option pricing, methods that until now have mostly been used for purely theoretical purposes. Pricing Derivatives the Martingale Way 1 Introduction There are two main approaches to the pricing of derivative securities. The first, due ...

Swap spreads, the interest rate differentials between the fixed rates on fixed-for-floating swap contracts and the yields-to-maturity on maturity-matched government bonds, define a market for one of the most actively transacted securities in the global fixed-income arena. A large universe of fixed-income securities including corporate bonds and mortgaged-back securities use interest rate swap spreads as a key benchmark for pricing and hedging. Swap spreads have received renewed attention since the Fall of 1998 when their volatile movements contributed in a significant way to the financial turmoil that led the US Fed to cut short-term interest rates by 75 basis points. In this paper we present new insights on how to analyze term structure of interest swap spreads. Specifically, we focus on the determinants of swap spreads and show how quantities such as the spread of short-term LIBOR over GC-repo rates, the liquidity premium commended by government bonds, and the risk premium required for holding long-term bonds/swaps jointly affect term structures of swap spreads.

stochastic volatility. ’ Of course, the authors take the full blame for any remaining error. Please address all correspondence

We introduce a criterion how to price derivatives in incomplete markets, based on the theory of growth optimal strategy in repeated multiplicative games. We present reasons why these growth-optimal strategies should be particularly relevant to the problem of pricing derivatives. Under the assumptions of no trading costs, and no restrictions on lending, we find an appropriate equivalent martingale measure that prices the underlying and the derivative security. We compare our result with other alternative pricing procedures in the literature, and discuss the limits of validity of the lognormal approximation. We also generalize the pricing method to a market with correlated stocks. The expected estimation error of the optimal investment fraction is derived in a closed form, and its validity is check with a small-scale empirical test. 1 This work was supported by the NFR contract S-FO 1778-302 2 and by I.N.F.M. grant-in-aid Preprint submitted to Elsevier Preprint 1 February 2008 1