This paper explores the e¡ect of equity volatility on corporate bond yields. Panel data for the late 1990s show that idiosyncratic ¢rm-level volatility can explain as much cross-sectional variation in yields as can credit ratings. This ¢nding, together with the upward trend in idiosyncratic equity volatility documented by Campbell, Lettau, Malkiel, and Xu (2001), helps to explain recent increases in corporate bond yields. DURING THE LATE 1990s, THE U.S. EQUITY and corporate bond markets behaved very di¡erently. As displayed in Figure 1, stock prices rose strongly, while at the same time, corporate bonds performed poorly. The proximate cause of the low returns on corporate bonds was a tendency for the yields on both seasoned and newly issued corporate bonds to increase relative to the yields of U.S.Treasury securities. These increases in corporate^Treasury yield spreads are striking because they occurred at a time when stock prices were rising; the optimism of stock market investors did not seem to be shared by investors in the corporate bond market.

Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firm’s cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit derivatives. While rating agencies such as Moodys and Standard & Poors compute historical default frequencies, option models can also be used to calculate forward looking or expected default frequencies. In this paper, we compute risk neutral probabilities or default (RNPD) using the diffusion models of Merton (1974) and Geske (1977). It is shown that the Geske model produces a term structure of RNPD’s, and the shape of this term structure may forecast impending credit events. Next, it is shown that these RNPD’s serve as bounds to estimates of actual default probabilities. Furthermore, the RNPD’s exhibit the same comparative statics as the estimates of actual default probabilities. Also, the risk neutral default probabilities may be more accurately estimated than actual default probabilities because they do not require an estimate of the firm’s drift. Given these similarities and advantages of RNPD’s, their estimates may possess significant information about credit events. To confirm this an event study of the relation between RNPD

conversations.

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.

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This paper explores the determinants of corporate failure and the pricing of financially distressed stocks whose failure probability, estimated from a dynamic logit model using accounting and market variables, is high. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with low failure risk. These patterns are more pronounced for stocks with possible informational or arbitrage-related frictions. They are inconsistent with the conjecture that value and size e¤ects are compensation for the risk of financial distress.

The Working Paper series presents reports on matters in the sphere of activities of the Riksbank that are considered to be of interest to a wider public. The papers are to be regarded as reports on ongoing studies and the authors will be pleased to receive comments. The views expressed in Working Papers are solely the responsibility of the authors and should not to be interpreted as reflecting the views of the Executive Board of Sveriges Riksbank.

Although much research has been done on external ratings, much less is known about banks ´ internal ratings. This paper aims at improving our understanding of internal risk rating systems at large banks and the way in which they are implemented, to verify if they will provide regulators with a consistent picture of banks ’ loan portfolio credit risk, as is envisioned in the Basel II Accord. An important property of our work is that we derive our measures of credit risk without making any assumptions about correlations between loans, due to the fact that the size of the data allows us to apply Carey’s [16] non-parametric Monte Carlore-samplingmethod. We find that default risk is most likely not homogeneous within rating classes, as regulators whould expect it to be.Our results also reveal substantial differences between the implied loss distributions of the two banks with equal "regulatory " risk profiles; both expected losses and the credit loss rates at a wide range of loss distribution percentiles vary considerably. Such variation is likely to translate into different levels of required economic capital. As a result, incentives could transpire for some banks to securitize part of their loan portfolio to

The Internal Ratings Based approach for the determination of required buffer capital is one of the cornerstones in the proposed revision of the Basel Committee rules for bank regulation. This paper is an attempt to empirically evaluate the IRB approach using historical businessloanportfoliodatafrom1994to2000foramajorSwedishbank. In particular, we study how the bank’s risk weighted assets change over time (had the bank been subject to the proposed rules). In order to better interpret the calculated risk-weighted capital as given by the new Accord, we have estimated a credit risk model. A VaR-type credit risk measure derived by simulation from the credit risk model allows us to better judge how adequate IRB-determined buffer capital is.

insights with me. Comments and suggestions from seminar participants at the Wharton school, University of Pennsylvania are gratefully acknowledged. All omissions and errors are my own. Why Do Firms Pay for Bond Ratings When They Can Get Them for Free? I investigate whether rating agencies (Moody’s and S&P) use consistent standards in solicited and unsolicited ratings, that is, whether agencies treat issuers who pay for the service (solicited rating) differently from those who do not pay (unsolicited rating). I find that both agencies give significantly lower ratings to unsolicited issues. However, I do not find a significant difference between the performances of solicited and unsolicited issues. The results are consistent with the hypothesis that rating agencies give worse ratings to un-soliciting issuers not as blackmail, but rather as a necessary adjustment for the difference in the true and unobserved quality. Holding public information constant, issuers with better private information self select into the soliciting group since by disclosing the private information to the agencies they can receive higher ratings. The results in this paper do not lend support for more stringent regulation on the rating agencies. 1 1.