This is the first study that computes default measures for individual firms using Merton’s (1974) option pricing model, to assess the effect that default risk has on equity returns. We find that equally-weighted portfolios of stocks with high default probability earn significantly higher returns than equally-weighted portfolio of stocks with low default probability. In addition, both the size and book-to-market effects are present only within the portfolio of stocks with the highest default probabilities. Once stocks with the 30 % highest default probabilities are excluded from the sample, both size and B/M effects disappear. We also find that default risk is priced and can explain part of the cross-sectional variation in returns. The Fama-French factors SMB and HML, and particularly SMB, contain some default-related information, although it appears that this information is not the driving force behind the success of the Fama-French model. Keywords: default risk, equity returns, Merton’s (1974) model, size and book-to-market. JEL classification: G33, G12 1

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In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the “optimum ” leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade-off model to simulate firms ’ capital structure paths. The results of standard cross-sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted. RECENT EMPIRICAL RESEARCH IN CAPITAL STRUCTURE focuses on regularities in the cross section of leverage to discriminate between various theories of financing policy. In this research, book and market leverage are related to profitabil-ity, book-to-market, and firm size. Changes in market leverage are largely ex-plained by changes in equity value. Past book-to-market ratios predict current

wish to thank Andre Haris, Lozan Bakayatov, and Davron Yakubov for their excellent data collection efforts. In addition, we thank the financial assistance of the Social Sciences and Humanities Research Council of Canada. All errors remain the responsibility of the authors. Corporate Yield Spreads and Bond Liquidity We examine whether liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4000 corporate bonds and spanning investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads; and that an improvement of liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers ’ fixed effect and potential endogeneity bias. Our finding mitigates the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants, and suggests that liquidity plays an important role in corporate bond valuation.

We test the theoretical equivalence of credit default swap (CDS) prices and credit spreads derived by Duffie (1999), finding support for the parity relation as an equilibrium condition. We also find two forms of deviation from parity. First, for three firms, CDS prices are substantially higher than credit spreads for long periods of time, arising from combinations of imperfections in the contract specification of CDSs and measurement errors in computing the credit spread. Second, we find short-lived deviations from parity for all other companies due to a lead for CDS prices over credit spreads in the price discovery process.

We construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring, and allows for compensation for illiquidity. Using a new and relatively efficient method, we estimate the model using Russian dollar-denominated bonds. We consider the determinants of the Russian yield spread, the yield differential across different Russian bonds, and the implications for market integration, relative liquidity, relative expected recovery rates, and implied expectations of different default scenarios.

This paper is a critical survey of models designed for pricing fixed income securities and their associated term structures of market yields. Our primary focus is on the interplay between the theoretical specification of dynamic term structure models and their empirical fit to historical changes in the shapes of yield curves. We begin by overviewing the dynamic term structure models that have been fit to treasury or swap yield curves and in which the risk factors follow diffusions, jump-diffusion, or have “switching regimes. ” Then the goodness-of-fits of these models are assessed relative to their abilities to: (i) match linear projections of changes in yields onto the slope of the yield curve; (ii) match the persistence of conditional volatilities, and the shapes of term structures of unconditional volatilities, of yields; and (iii) to reliably price caps, swaptions, and other fixed-income derivatives. For the case of defaultable securities we explore the relative fits to historical yield spreads. 1

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Analytical tractability is one of the challenges faced by many alternative models that try to generalize the Black-Scholes option pricing model to incorporate more empirical features. The aim of this paper is to extend the analytical tractability of the Black-Scholes model to alternative models with jumps. We demonstrate a double exponential jump diffusion model can lead to an analytic approximation for Þnite horizon American options (by extending the Barone-Adesi and Whaley method) and analytical solutions for popular path-dependent options (such as lookback, barrier, and perpetual American options). Numerical examples indicate that the formulae are easy to be implemented and accurate.

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