This paper empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Leland and Toft (1996), Longsta# and Schwartz (1995), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986-1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet su#er from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely a#ecting the spreads of the safest bonds.

In this paper, we examine the dynamic behavior of credit spreads on corporate bond portfolios. We propose an econometric model of credit spreads that incorporates portfolio rebalancing, the near unit root property of spreads, the autocorrelation in spread changes, the ARCH conditional heteroscedasticity, jumps, and lagged market factors. In particular, our model is the first that takes into account explicitly the impact of rebalancing and yields estimates of the absorbing bounds on credit spreads induced by such rebalancing. We apply our model to nine Merrill Lynch daily series of option-adjusted spreads with ratings from AAA to C for the period January, 1997 through August, 2002. We find no evidence

We examine the question of the determinants of corporate bond credit spreads using both weekly and monthly option-adjusted spreads for nine corporate bond indexes from Merrill Lynch from January 1997 to July 2002. We find that the Russell 2000 index historical return volatility and the Conference Board composite leading and coincident economic indicators have significant power in explaining credit spread changes, especially for high yield indexes. Further-more, these three variables plus the interest rate level, the historical interest rate volatility, the yield curve slope, the Russell 2000 index return, and the Fama-French [1996] high-minus-low factor can explain more than 40 % of credit spread changes for five bond indexes. In particular,

Though there are several theoretical lease pricing models, they have not been systematically estimated or tested using real data. The existing empirical literature on leases typically tries to explain one period’s lease payment, ignoring how fast those payments are scheduled to grow, or whether the lease contains option features. This paper bridges the gap between the two literatures by providing the first empirical investigation of an internally consistent lease pricing model. We develop a no-arbitrage based valuation model that allows us to calculate each lease’s NPV taking into account both the contractual payment amounts and any embedded options. Using a proprietary data set of several hundred leases from suburban malls in 11 states, we then compare the NPV of each lease with various characteristics of the leases and underlying properties, to see what characteristics are important, and how the underlying valuation model can be improved.

This paper calculates loan-by-loan estimates of commercial real estate implied volatility using all commercial mortgages in 206 public CMBS deals from 1996 through 2005 — a total of over 14,000 loans. The implied volatilities average about 20–24 % per annum, with some differences across property types. Using these implied volatilities, we compute the distribution of default rates for representative CMBS pools under realistic assumptions, and find that the subordination levels for recent vintages of CMBS imply a high likelihood of default for what are supposed to be investment-grade tranches.

Some modified structural and reduced-form models of credit risk implicitly assume that the market has less information than managers who declare default on their outstanding debt. As a result the announcement of default or disclosure of information that indicates a firm is in distress comes as a “surprise ” to the market. In this paper, we study the extent to which private information is revealed about a firm when it announces information indicating distress. The presence of this private information can be inferred from the extent to which investors can earn abnormal returns on bonds or equities issued by firms announcing distress or default. We analyze how much of the information revealed through the declaration of a credit event is publicly available before a specific announcement of credit difficulties. Using default probabilities supplied by Moody’s KMV (MKMV), known as the Expected Default Frequency�or the EDF�credit measure, we model market expectations regarding the firm’s likelihood of default. We then measure the impact of information revealed through an adverse credit event conditional on this expectation. We find that conditioning on EDF credit measures, only 11 % of the distressed firms’ equities and 18 % of the distressed bonds (belonging to 25 % of the distressed firms) display a

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.

This paper analyzes corporate bond valuation and optimal call and default rules when interest rates and firm value are stochastic. It then uses the results to explain the dynamics of hedging. Bankruptcy rules are important determinants of corporate bond sensitivity to interest rates and firm value. Although endogenous and exogenous bankruptcy models can be calibrated to produce the same prices, they can have very different hedging implications. We show that empirical results on the relation between corporate spreads and Treasury rates provide evidence on duration and find that the endogenous model explains the empirical patterns better than typical exogenous models. Corporate bonds are standard investment instruments, yet the embedded options they contain are quite complex. Most corporate bonds are callable and call provisions interact with default risk. In any case, corporate bond investors face the problem of managing interest rate and credit risk simultaneously. This paper examines the valuation and risk management of callable defaultable bonds when both interest rates and firm value are stochastic and when the issuer follows optimal call and default rules. To our knowledge, this is the first model of couponbearing

This paper analyzes corporate bond valuation of a straight bond, and the convertibility feature, when interest rates are stochastic and the firm value is determined by the interaction of a series of stochastic variables. The sensitivity of the corporate debt value to some key parameters is also explored. The methodology applied here is based on a hybrid of simulation and dynamic programming proposed by Raymar and Zwecher in 1997 to value financial American-type options. This methodology proves to be extremely efficient to value American-type options when the sources of uncertainty are numerous.

This paper employs a new approach to estimating the size of liquidity premia in the credit default swap (CDS) and corporate bond markets. We develop a CDS pricing model with liquidity and default, and a corporate bond pricing model with default, taxes, and liquidity using the reduced-form approach, and jointly estimate parameters of both pricing models from pooled data using the generalized method of moments. By formulating default intensity as a common factor of the spreads of the CDS and reference bonds, we are able to identify the liquidity and other components of spreads more precisely. We find that both CDS and corporate bond spreads contain significant liquidity components. On average, the liquidity premium accounts for 13 % of the CDS spread and 23 % of the corporate yield spread. The size of the liquidity premium increases as the rating decreases. Estimates of liquidity premia in the CDS and corporate bond markets are highly correlated, and closely linked to bond-specific and aggregate liquidity measures. Results show that liquidity is important for CDS and corporate bond pricing. Ignoring CDS illiquidity results in a significant bias in estimation of corporate yield spread components when using the CDS information to aid in decomposition of spreads.