We show that the abnormal returns on high-default risk stocks documented by Vassalou and Xing (2004) are driven by short-term return reversals rather than systematic default risk. These abnormal returns occur only during the month after portfolio formation and are concentrated in a small subset of stocks that had recently experienced large negative returns. Empirical evidence supports the view that the short-term return reversal arises from a liquidity shock triggered by a clientele change.

Employing a large number of real and financial indicators, we use Bayesian Model Averaging (BMA) to forecast real-time measures of economic activity. Importantly, the predictor set includes option-adjusted credit spread indexes based on bond portfolios sorted by maturity and credit risk as measured by the issuer’s “distance-to-default. ” The portfolios are constructed directly from the secondary market prices of outstanding senior unsecured bonds issued by a large number of U.S. corporations. Our results indicate that relative to an autoregressive benchmark, BMA yields consistent improvements in the prediction of the growth rates of real GDP, business fixed investment, industrial production, and employment, as well as of the changes in the unemployment rate, at horizons from the current quarter (i.e., “nowcasting”) out to four quarters hence. The gains in forecast accuracy are statistically significant and economically important and owe exclusively to the inclusion of our portfolio credit spreads in the set of predictors—BMA consistently assigns a high posterior weight to models that include these financial indicators. JEL Classification: C11, C53

Using credit default swaps (CDS) to imply a …rm’s or sovereign’s default probability is laden with di ¢ culties, making the resulting estimate unreliable. This paper exposes these di ¢ culties using a simple analogy to life insurance premiums. An analogy is used because the logic is more easily understood in this context. The di ¢ culties are unraveling the impact of risk premium, counterparty risk, market frictions, and strategic trading. Given a well understood alternative to implied CDS default probabilities is available, actuarial based default probabilities, banking regulations and risk management decisions should not be based on CDS implied default probabilities. 1

Rating agencies claim to look through the cycle when assigning corporate credit ratings, which entails that they are able to separate trend components of default risk from transitory ones. To test whether agencies possess this competence, I take market-based estimates of one-year default probabilities of corporate bond issuers and estimate their long-run trend using the Hodrick-Prescott filter, local regression, or centered moving averages. I find that ratings help identify the current split into trend and cycle. Their stability is similar to the one of hypothetical ratings based on trends. Since the examined trends are forward-looking, agency ratings exhibit important characteristics one would expect from ratings that see through the cycle. Key words: credit ratings, through-the-cycle, Hodrick-Prescott filter.

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We investigate how the age of an organization affects its life expectancy. Few, if any, firms survive over time. The main problem is takeover rather than financial failure. Most firms disappear because they are recycled in other firms. Takeover hazard initially declines, and then intensifies as firms grow older. This phenomenon is unrelated to management and industry age, and particularly intensive in high-tech, research-, and capital-intensive industries. Firms seem to have an aging problem. When they get older they increasingly seek outside help to function. The evidence is consistent with a corporate life cycle.

Individual investors often invest actively and lose thereby. Social interaction seems to exacerbate the bias toward active trading. In the model here, conversational biases in the social transmission of performance information favor active over passive investment strategies. Senders ’ propensity to communicate their returns is increasing in returns. Receivers’ propensity to attend to and be converted by senders is increasing and convex in sender return. Active strategies (high variance, skewness, and personal involvement) dominate the population unless the mean return penalty to active investing is too large. Thus, the model can explain overvaluation of assets with these characteristics even if investors have no inherent preference over them.

Modern financial engineering has dedicated significant effort in developing sophisticated option pricing models to replicate the implied volatility smirk anomaly. Nonetheless, there is limited empirical evidence to examine the causes of this anomaly implied by market options data. The primary purpose of this study is to investigate the time-series economic determinants that affect the shape of the S&P 500 index Implied Volatility Function (IVF). The analysis is carried out on a daily basis and covers the period from January 1998 to December 2007. One of the most important contributions of this study is to investigate how the market default risk affects the shape of the risk-neutral density function implied by the S&P 500 index options. In order to create the proxy for the market default risk, I compute the daily probability-to-default measure for all individual, non-financial, firms included in the S&P 500 index. The daily probability-to-default is calculated with the Merton distance-to-default measure, which is based on Merton’s (1974) option pricing model. Part of my analysis includes discussions of the different versions of the default risk that I compute and compare with some key results reported in Bharath and Shumway (2008). My analysis shows that the market default risk has a dual role to play, since it can potentially capture both, the market leverage effect, as well as, the market’s perceptions about the future growth/state of the economy. As such, market default risk has been found to affect the shape of the S&P 500

We hypothesize that the degree of public attention influences the price level of stocks in a systematic way. We employ a simple discounted cash flow model with adverse selection and fixed transaction costs that determine an endogenous bid-ask-spread. In the model, rational and risk neutral investors incorporate future trading conditions into their price setting behavior. These trading conditions are driven by the degree of public attention and entail an attention-dependent impact of the bid-ask-spread on required gross returns. Specifically, given a high level of public attention a higher bid-ask-spread may negatively affect required asset returns. We argue that the model implications are consistent with empirical findings, i.e. size, bookto-market, and the momentum effect.

This paper develops a structural credit risk model to characterize the difference between the economic and recorded default times for a firm. Recorded default occurs when default is recorded in the legal system. The economic default time is the last time when the firm is able to pay off its debt prior to the legal default time. It has been empirically documented that these two times are distinct (see Guo, Jarrow, and Lin (2008)). In our model, the probability distribution for the time span between economic and recorded defaults follows a mixture of Arcsine Laws, which is consistent with the results contained in Guo, Jarrow, and Lin. In addition, we show that the classical structural model is a limiting case of our model as the time period between debt repayment dates goes to zero. As a corollary, we show how the firm value process’s parameters can be estimated using the tail index and correlation structure of the firm’s return.