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150
Default risk and equity returns
 Journal of Finance
, 2004
"... 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 equallyweighted portfolios of stocks with high default probability earn significantly higher returns tha ..."
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Cited by 137 (1 self)
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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 equallyweighted portfolios of stocks with high default probability earn significantly higher returns than equallyweighted portfolio of stocks with low default probability. In addition, both the size and booktomarket 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 crosssectional variation in returns. The FamaFrench factors SMB and HML, and particularly SMB, contain some defaultrelated information, although it appears that this information is not the driving force behind the success of the FamaFrench model. Keywords: default risk, equity returns, Merton’s (1974) model, size and booktomarket. JEL classification: G33, G12 1
Corporate Yield Spreads and Bond Liquidity
 Journal of Finance
, 2007
"... 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 an ..."
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Cited by 117 (3 self)
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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 bondspecific, firmspecific, 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.
Liquidity and credit risk
 Journal of Finance
, 2006
"... We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attrib ..."
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Cited by 57 (0 self)
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We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years, we find evidence of a positive correlation between the illiquidity and default componentsofyieldspreadsaswellassupportfordownwardslopingtermstructuresof liquidity spreads. Credit risk and liquidity risk have long been perceived as two of the main justifications for the existence of yield spreads above benchmark Treasury notes or bonds (see Fisher (1959)). Since Merton (1974), a rapidly growing body of literature has focused on credit risk. 1 However, while concern about market liquidity issues has become increasingly marked since the autumn of 1998, 2 liquidity remains a relatively unexplored topic, in particular, liquidity for defaultable securities. 3 This paper develops a structural bond pricing model with liquidity and credit risk. The purpose is to enhance our understanding of both the interaction between these two sources of risk and their relative contributions to the yield spreads on corporate bonds. Throughout the paper, we define liquidity as the ability to sell a security promptly and at a price close to its value in frictionless markets, that is, we think of an illiquid market as one in which a sizeable discount may have to be incurred to achieve immediacy. We model credit risk in a framework that allows for debt renegotiation as in Fan and Sundaresan (2000). Following François and Morellec (2004), we also introduce
Forecasting Default with the KMVMerton Model, Working paper
, 2004
"... We examine the accuracy and contribution of the default forecasting model based on Merton’s (1974) bond pricing model and developed by the KMV corporation. Comparing the KMVMerton model to a similar but much simpler alternative, we find that it performs slightly worse as a predictor in hazard model ..."
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Cited by 52 (0 self)
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We examine the accuracy and contribution of the default forecasting model based on Merton’s (1974) bond pricing model and developed by the KMV corporation. Comparing the KMVMerton model to a similar but much simpler alternative, we find that it performs slightly worse as a predictor in hazard models and in out of sample forecasts. Moreover, several other forecasting variables are also important predictors, and fitted hazard model values outperform KMVMerton default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with KMVMerton default probabilities after adjusting for agency ratings, bond characteristics, and our alternative predictor. We conclude that the KMVMerton model does not produce a sufficient statistic for the probability of default, and it appears to be possible to construct such a sufficient statistic without solving the simultaneous nonlinear equations required by the KMVMerton model. We include the SAS code we use to calculate KMVMerton default probabilities in an appendix.
Stock Options and Credit Default Swaps: A Joint Framework for Valuation and Estimation
 JOURNAL OF FINANCIAL ECONOMETRICS, 2009, 1–41
, 2009
"... We propose a dynamically consistent framework that allows joint valuation and estimation of stock options and credit default swaps written on the same reference company. We model default as controlled by a Cox process with a stochastic arrival rate. When default occurs, the stock price drops to zero ..."
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Cited by 51 (8 self)
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We propose a dynamically consistent framework that allows joint valuation and estimation of stock options and credit default swaps written on the same reference company. We model default as controlled by a Cox process with a stochastic arrival rate. When default occurs, the stock price drops to zero. Prior to default, the stock price follows a jumpdiffusion process with stochastic volatility. The instantaneous default rate and variance rate follow a bivariate continuous process, with its joint dynamics specified to capture the observed behavior of stock option prices and credit default swap spreads. Under this joint specification, we propose a tractable valuation methodology for stock options and credit default swaps. We estimate the joint risk dynamics using data from both markets for eight companies that span five sectors and six major credit rating classes from B to AAA. The estimation highlights the interaction between market risk (return variance) and credit risk (default arrival) in pricing stock options and credit default swaps.
How the Subprime Crisis Went Global: Evidence from Bank Credit Default Swap Spreads,” NBER Working Paper No. 14904
, 2009
"... How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks ’ credit default swap spreads. We find that fortunes of ..."
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Cited by 44 (4 self)
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How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks ’ credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with shortterm global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the preLehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman’s failure, the prospect of global recession became imminent, auguring the further deterioration of banks ’ loan portfolios. At this point the entire global financial system had become infected. 1
A jump to default extended CEV model: An application of Bessel processes
, 2005
"... We consider the problem of developing a ßexible and analytically tractable framework which uniÞes the valuation of corporate liabilities, credit derivatives, and equity derivatives. Theory and empirical evidence suggest that default indicators such as credit default swap (CDS) spreads and corporate ..."
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Cited by 37 (3 self)
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We consider the problem of developing a ßexible and analytically tractable framework which uniÞes the valuation of corporate liabilities, credit derivatives, and equity derivatives. Theory and empirical evidence suggest that default indicators such as credit default swap (CDS) spreads and corporate bond yields are positively related to historical volatility and implied volatilities of equity options. Theory and empirical evidence also suggest that a stocks realized volatility is negatively related to its price (leverage effect) and that implied volatilities are decreasing in the options strike price (skew). We propose a parsimonious reducedform model of default which captures all of these fundamental relationships. We assume that the stock price follows a diffusion, punctuated by a possible jump to zero (default). To capture the positive link between default and volatility, we assume that the hazard rate of default is an increasing affine function of the instantaneous variance of returns on the underlying stock. To capture the negative link between volatility and stock price, we assume a Constant Elasticity of Variance (CEV) speciÞcation for the instantaneous stock volatility prior to default. We show that deterministic changes of time and scale reduce our
C.T.,2011, Regulatory pressure and fire sales in the corporate bond market
 Journal of Financial Economics
"... This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculativegrade bonds. As insurance companies hold over one third of all outstandin ..."
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Cited by 29 (1 self)
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This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculativegrade bonds. As insurance companies hold over one third of all outstanding investmentgrade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Using insurance company transaction data from 20012005, we find insurance companies that are relatively more constrained by regulation are, on average, more likely to sell downgraded bonds. This forced selling generates elevated selling pressure around the downgrade which causes price pressures and subsequent price reversals, indicative of significant periods during which transaction prices deviate from fundamental values. Conditionally, the selling pressure, as well as the resulted price reversals, appears larger during periods in which insurance companies as a group are more constrained and other potential buyers ’ capital is scarce. In the cross section, bonds widely held by constrained insurance companies experience significantly larger selling pressure and larger price reversals. Investors providing liquidity to this market appear to earn