This article incorporates a time-varying severity of disasters into the hy-

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Abstract This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that liquidity risk is a priced factor for the expected returns on corporate bonds. The exposures of corporate bond returns to fluctuations in treasury bond liquidity and equity market liquidity help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.45% for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1%. We find very similar evidence for the liquidity risk exposure of corporate bonds using a sample of European corporate bond prices. * Liquidity Risk Premia in Corporate Bond Markets Abstract This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that liquidity risk is a priced factor for the expected returns on corporate bonds. The exposures of corporate bond returns to fluctuations in treasury bond liquidity and equity market liquidity help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.45% for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1%. We find very similar evidence for the liquidity risk exposure of corporate bonds using a sample of European corporate bond prices.

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The central insight of asset pricing is that a security’s value depends on both its distribution of payo¤s across economic states and state prices. In …xed income markets, many investors focus exclusively on estimates of expected payo¤s, such as credit ratings, without considering the state of the economy in which default is likely to occur. Such investors are likely to be attracted to securities whose payo¤s resemble those of economic catastrophe bonds–bonds that default only under severe economic conditions. We show that many structured …nance instruments can be characterized as economic catastrophe bonds, but o¤er far less compensation than alternatives with comparable payo ¤ pro…les. We argue that this di¤erence arises from the willingness of rating agencies to certify structured products with a low default likelihood as “safe ” and from a large supply of investors who view them as such.

Individual stock-option prices and credit spreads Cremers, M.; Driessen, J.J.A.G.; Maenhout, P.; Weinbaum, D. General rights It is not permitted to download or to forward/distribute the text or part of it without the consent of the author(s) and/or copyright holder(s), other than for strictly personal, individual use, unless the work is under an open content license (like Creative Commons). Disclaimer/Complaints regulations If you believe that digital publication of certain material infringes any of your rights or (privacy) interests, please let the Library know, stating your reasons. In case of a legitimate complaint, the Library will make the material inaccessible and/or remove it from the website. Please Ask the Library: https://uba.uva.nl/en/contact, or a letter to: Library of the University of Amsterdam, Secretariat, Singel 425, 1012 WP Amsterdam, The Netherlands. You will be contacted as soon as possible. Abstract This paper introduces measures of volatility and jump risk that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain useful information for credit spreads and improve on historical volatilities when explaining the cross-sectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and (to a lesser extent) the implied-volatility skew matter for credit spreads. Detailed principal component analysis shows that a large part of the time-series variation in credit spreads can be explained in this way. JEL Classification: G12 ; G13

We propose a two-sided jump model for credit risk by extending the Leland-Toft endogenous default model based on the geometric Brownian motion. The model shows that jump risk and endogenous default can have significant impacts on credit spreads, optimal capital structure, and implied volatility of equity options: (1) The jump and endogenous default can produce a variety of non-zero credit spreads, including upward, humped, and downward shapes; interesting enough, the model can even produce, consistent with empirical findings, upward credit spreads for speculative grade bonds. (2) The jump risk leads to much lower optimal debt/equity ratio; in fact, with jump risk, highly risky firms tend to have very little debt. (3) The two-sided jumps lead to a variety of shapes for the implied volatility of equity options, even for long maturity options; and although in generel credit spreads and implied volatility tend to move in the same direction under exogenous default models, but this may not be true in presence of endogenous default and jumps. In terms of mathematical contribution, we give a proof of a version of the “smooth fitting ” principle for the jump model, justifying a conjecture first suggested by Leland and Toft under the Brownian model. 1

This paper extends the jump detection method based on bi-power variation to identify realized jumps on financial markets and to estimate parametrically the jump intensity, mean, and variance. Finite sample evidence suggests that jump parameters can be accurately estimated and that the statistical inferences can be reliable, assuming that jumps are rare and large. Applications to equity market, treasury bond, and exchange rate reveal important differences in jump frequencies and volatilities across asset classes over time. For investment grade bond spread indices, the estimated jump volatility has a better forecasting power than the interest rate factors, volatility factors including option-implied volatility, with control for systematic risk factors. A market jump risk factor seems to capture the low frequency movements in credit spreads.

This study empirically examines the impact of the interaction between market and default risk on corporate credit spreads. Using credit default swap (CDS) spreads, we find that average credit spreads decrease in GDP growth rate, but increase in GDP growth volatility and jump risk in the equity market. At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads generally rise with cash flow volatility and beta, with the effect of cash flow beta varying with market conditions. We identify implied volatility as the most significant determinant of default risk among firm-level characteristics. Overall, a major portion of individual credit spreads is accounted for by firm-level determinants of default risk, while macroeconomic variables are directly responsible for a lesser portion.

We develop a simple robust link between deep out-of-the-money American put options on a company's stock and a credit insurance contract on the company's bond. We assume that the stock price stays above a barrier B before default but drops below a lower barrier A after default, thus generating a default corridor [ A, B] that the stock price can never enter. Given the presence of this default corridor, a spread between two co-terminal American put options struck within the corridor replicates a pure credit contract, paying off when and only when default occurs prior to the option expiry. (JEL C13, C51, G12, G13) In a classic paper, Merton (1974) links a firm's equity and its debt through their common status as contingent claims on the assets of the firm. In his model, the firm has a simple capital structure, consisting of a single zero-coupon bond and equity. The firm's shareholders default at the debt's maturity date if the firm's value is below the debt principal at that time. Under this structural model, the credit spread on the bond becomes a function of the firm's financial leverage and its asset volatility. The financial leverage links equity to debt and relates firm volatility to equity volatility. Various modifications and extensions on the debt structure, default triggering mechanism, firm value dynamics, and We thank Raman Uppal (the editor), an anonymous referee,