This article presents a framework for studying the role of recovery on defaultable debt prices for a wide class of processes describing recovery rates and default probability. These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employed to infer the market expectation of recovery rates implicit in bond prices. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices.

We propose an empirical study on the pricing effect of liquidity level and liquidity risk in the credit default swaps (CDS) market. CDS is the key constituent of the fast growing credit derivatives market that has $34.4 trillion in total notional value by the end of 2006. Credit derivatives play an important role in today’s financial market by facilitating the transfer of credit risk. Credit derivatives are over-the-counter contracts executed through bilateral search. Trading motives include both credit risk management and, probably more notably, informed speculation. Government regulators around the globe have repeatedly expressed their concerns over the opacity and lack of comprehension of the credit derivatives market. A better understanding of the liquidity structure and its impact on the pricing of credit derivatives is critical to improving the efficiency and stability of financial markets and the overall health of the economy, as evidenced by the ongoing subprime mortgage crisis. Our study represents the first systematic investigation of the effect of CDS liquidity charac-teristics and liquidity risk on CDS spreads, above and beyond the credit risk component. We first construct a set of liquidity proxies to capture various facets of CDS liquidity, such as ad-verse selection, search frictions, and inventory costs, using a comprehensive database on CDS

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Any opinions expressed here are those of the author(s) and not those of the IIIS. All works posted here are owned and copyrighted by the author(s). Papers may only be downloaded for personal use only. Gady Jacoby† Department of Accounting and Finance, I.H. Asper School of Business,

We use a state-space model to represent the time-variation of credit spread indices by rating as a function of latent factors of the Vasicek form. By application of the Kalman Filter we simultaneously estimate the factor realizations, their process parameters, and the exposure of each observed credit spread series to each factor. A three-factor model is found to capture most of the time-variation in credit spreads across ratings, for any given maturity. Most significantly, the extracted factor series are closely correlated with the long bond rate, the implied volatility index (VIX), and the S&P500 level, suggesting that the three variables can explain the systematic variation in credit spreads across the quality spectrum. 2 I.

This paper models a firm’s rollover risk generated by conflict of interest between debt and equity holders. When the firm faces losses in rolling over its maturing debt, its equity holders are willing to absorb the losses only if the option value of keeping the firm alive justifies the cost of paying off the maturing debt. Our model shows that both deteriorating market liquidity and shorter debt maturity can exacerbate this externality and cause costly firm bankruptcy at higher fundamental thresholds. Our model provides implications on liquidity-spillover effects, the flight-to-quality phenomenon, and optimal debt maturity structures.

This paper models the e¤ect of debt market liquidity on …rms ’ credit risk through debt rollover. When deterioration of debt market liquidity causes a …rm to su¤er losses in rolling over its maturing debt, equity holders bear the losses while maturing debt holders get paid in full. This con‡ict can lead the …rm to default even when its fundamental is still high. As a result, the liquidity deterioration leads to not only a higher liquidity premium but also a higher default premium. Our model explains ‡ight to quality and demonstrates the role of short-term debt in exacerbating rollover risk.

This paper investigates factors that contribute to the cross-sectional pattern of spreads in Asset-Backed Security (ABS) prices in times of crisis. The periods include the crisis in the Manufactured Housing sector in 2004 and the turmoil in mortgage backed ABS in 2007. The cross section of prices for a given rating category appear to be poorly explained by liquidity and risk and there is evidence of a collapse in market confidence in the ratings agency classifications. ∗We thank Mariam Harfush-Pardo and Diep Ho. The authors ’ may be contacted at Tanaka

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.

In this paper I analyze how debt structure and the strategic interaction between shareholders and creditors in the event of default a¤ect expected stock returns. By endogenizing shareholders’decision to default, the model generates new predictions linking …rm characteristics to expected stock returns through an intuitive economic mechanism. In particular, the model predicts that expected stock returns are higher for …rms that face high debt renegotiation di ¢ culties, and that have a large fraction of secured or convertible debt. Expected stock returns are lower for …rms whose shareholders maintain strong bargaining power, and for …rms subject to high liquidation costs. Using a large sample of publicly traded US …rms between 1985 and 2005, I present new evidence on the link between debt structure, renegotiation frictions, and stock returns, which is supportive of the model’s predictions.