Default Risk and Equity Returns: Evidence from the Taiwan Equities Market

Studies of risk and return characteristics of different portfolios have recently gained enormous attention. Differing from past studies, this paper uses a compound option model to build the proxy of default risk and evaluate the relationship between default risk effect and equity returns. The primary goal of this paper is to evaluate the relationship among default risk, size, book-to-market, and equity returns, using data drawn from the Taiwan equities market, and to also examine whether size and book-to-market are proxies for default risk. The results show that the effects of size and book-to-market exist in different default portfolios when default risks are controlled. If size or book-to-market is controlled, there are no default effects. In the regression analysis, when default risk is included in Fama and French’s Three Factor Model, it shows that size, book-to-market and default risk have significant influence on equity returns and default risk is a systematic risk. Default risk is also more powerful in explaining returns when the compound option model is adopted for estimating default risks.     

Do U.S. Insurance Firms Offer the “Wrong” Incentives to Their Executives?

We examine the relation between executive compensation and market‐implied default risk for listed insurance firms from 1992 to 2007. Shareholders are expected to encourage managerial risk sharing through equity‐based incentive compensation. We find that long‐term incentives and other share‐based plans do not affect the default risk faced by firms. However, the extensive use of stock options leads to higher future default risk for insurance firms. We argue that this is because option‐based incentives induce managerial risk‐taking behavior, which seeks to maximize managerial payoff through equity volatility. This could be detrimental to the interests of shareholders, especially during a financial crisis.     

Rollover Risk and Credit Risk

Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms' debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debt holders are paid in full. This conflict leads the firm to default at a higher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short‐term debt in exacerbating rollover risk.     

Credit Derivatives and the Default Risk of Large Complex Financial Institutions

This paper proposes and implements a multivariate model of the coevolution of the first and second moments of two broad credit default swap indices and the equity prices of sixteen large complex financial institutions. We use this empirical model to build a bank default risk model, in the vein of the classic Merton-type, which utilises a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the conditions of the global credit environment. In the first step, we estimate the dynamic correlations and volatilities describing the evolution of the CDS indices and the banks’ equity prices and then impute the implied assets and their volatilities conditional on the evolution and volatility of equity. In the second step, we show that there is a substantial ‘asset shortfall’ and that substantial capital injections and/or asset insurance are required to restore the stability of our sample institutions to an acceptable level following large shocks to the aggregate level of credit risk in financial markets.     

Does tax convexity matter for risk? A dynamic study of tax asymmetry and equity beta

The purpose of this study is to explore the effect of tax convexity on firms’ market risk, where tax convexity measures the progressivity of firms’ tax function. We examine the relation between equity beta and tax convexity based on a standard contingent-claims model, in which firms face nonlinear tax schedules. We verify that in the presence of default and growth options, the effect of tax convexity on beta is significant and depends on several countervailing forces. Tax convexity has a direct, positive effect on beta, as well as two indirect countereffects through default and growth options. The overall effect is ambiguous and quantitatively significant. As asymmetric tax schedules are used in most countries, assuming a linear tax schedule in the valuation framework may misestimate beta and thus fail to assess risk accurately. Our theoretical model shows that tax convexity should be taken into consideration when estimating equity beta.     

Market conditions,default risk and 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.     

A framework to measure integrated risk

A framework underlying various models that measure the credit risk of a portfolio is extended in this paper to allow the integration of credit risk with a range of market risks using Monte Carlo simulation. A structural model is proposed that allows interest rates to be stochastic and provides closed-form expressions for the market value of a firm's equity and its probability of default. This model is embedded within the integrated framework and the general approach illustrated by measuring the risk of a foreign exchange forward when there is a significant probability of default by the counterparty. For this example moving from a market risk calculation to an integrated risk calculation reduces the expected future value of the instrument by an amount that could not be calculated using the common pre-settlement exposure technique for estimating the credit risk of a derivative.     

Financial Distress and the Cross‐section of Equity Returns

We explicitly consider financial leverage in a simple equity valuation model and study the cross‐sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book‐to‐market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump‐shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.     

Original-Issue Systematic and Default Risk Pricing Efficiency of Speculative-Grade Bonds

We investigate whether primary market, original‐issue risk premiums on speculative‐grade debt are justified solely by expected defaults or whether these risk premiums also include other orthogonal risk components. Studies of secondary‐market holding period risk and return have hypothesized that risk premiums on speculative‐grade debt may be explained by bond‐ and equity‐related systematic risk and possibly other types of risk. Using an actuarial approach that considers contemporaneous correlation between default frequency and severity and first‐order serial correlation, we cannot reject the hypothesis that the entire original‐issue risk premium can be explained by expected default losses. This suggests that speculative‐grade bond primary markets efficiently price default risk and that other types of risk are priced as coincident as opposed to orthogonal risks.     

The risk appetite of private equity sponsors

Using a unique proprietary data set of 460 realized buyouts completed between 1990 and 2005, we examine the risk appetite of private equity (PE) sponsors in different states of the PE market and analyze key determinants of deal-level equity risk. We develop a new approach to mathematically model PE investment equity risk based on the Black-Cox default model. We find higher equity volatilities during boom periods. Further, deals conducted by more reputed PE sponsors have lower equity volatilities as they are unwilling to imperil their reputation by taking excessive risks. In addition, we find that PE sponsors' risk appetite is negatively related to the ownership stake in the buyout target company.     

Mandated accounting changes and debt covenants: The case of oil and gas accounting

The relationships among mandated accounting changes, bond covenants and security prices has been the focus of several studies. These studies have provided mixed evidence on the existence of a bond covenant effect on security prices. This paper suggests that inconclusive prior results are a consequence of inappropriately measuring the default risk of debt. Using an option pricing framework, it is shown that the debt to equity alone is not an adequate measure of default risk. In particular, both the debt to equity ratio and the total risk of the firm are necessary to adequately model the bond covenant effects of an accounting change. These theoretical propositions are supported by the empirical analysis of the security market reaction to changes in oil and gas accounting.     

A Reexamination of the Tradeoff between the Future Benefit and Riskiness of R&D Increases

Many previous studies document a positive relation between research and development (R&D) and equity value. Though R&D can increase equity value by increasing firm value, it can also increase equity value at the expense of bondholder wealth through an increase in firm risk because equity is analogous to a call option on the underlying firm value. Shi [2003] tests this hypothesis by examining the relation between a firm's R&D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of R&D is negative for bondholders. We reexamine Shi's [2003] findings and in so doing make three contributions to the literature. First, we find that Shi's [2003] results are sensitive to the method of measuring R&D intensity. When we use what we argue is a better measure of R&D intensity, we find that the net effect of R&D is positive for bondholders. Second, when we use tests that Shi [2003] recognizes are even better than the ones that he uses, we find even stronger evidence of the positive effect of R&D on bondholders. Third, we examine cross‐sectional differences in the effect of R&D on debtholders. Consistent with our main finding, we document a negative relation between R&D increases and default risk. The default risk reduction is also more pronounced for firms with higher initial default scores (where the debtholders have more to gain from an R&D increase) and for firms with more bank debt (where the debtholders have greater covenant protection from the possible detriments associated with R&D increases).     

Liquidity and CDS premiums on European companies around the Subprime crisis

This paper sheds new light on the liquidity dynamics of the credit default swaps (CDS) market in Europe around the Subprime crisis. Based on an original dataset of 94 European companies from 2005 to 2009, we use a panel regression analysis to study the relationship between CDS premiums and liquidity. We measure the level of liquidity, look at liquidity risk, and study the liquidity spillovers from the bond and equity markets to the CDS market. We show that the effect of liquidity on CDS premiums is dominated by the influence of worsening credit conditions and deteriorating investors?? expectations about default risk. Controlling for credit risk, we also find that liquidity risk is priced in the European CDS market and that liquidity spillovers from the bond market matter in determining CDS premiums.     

Is default risk the hidden factor in momentum returns? Some empirical results

This paper analyzes the role of default risk in the momentum effect focusing on data from four developed European stock markets (France, Germany, Spain and the United Kingdom). Using a market‐based measure of default risk, we show that it is not the hidden factor behind this effect. While the loser portfolio is characterized by high default risk, small size, high book‐to‐market and illiquidity, characterization of the winner portfolio is somewhat more complex. Given that the momentum strategy is the return differential between the winners and the losers, factors such as the stock market cycle or the evolution of momentum portfolios against their reference point make momentum profits difficult to forecast.     

Mortgage defaults

A life-cycle model is developed in which households face income and house-price risk and buy houses with mortgages. This model, which accounts for key features in U.S. data, is used as a laboratory for prudential policy. Recourse mortgages increase the cost of default but also lower equity and increase payments. The effect on default is nonmonotonic. Loan-to-value (LTV) limits increase equity and lower the default rate, with negligible effects on housing demand. Combining recourse mortgages and LTV limits reduces the default rate while boosting housing demand. Together, they also prevent spikes in default after large declines in aggregate house prices.     

The Effects of Relative Changes in CEO Equity Incentives on the Cost of Corporate Debt

We examine how effort and risk incentives embedded in CEO equity incentives are related to the cost of debt and the role credit worthiness plays in this relationship. Our empirical approach addresses a number of unanswered questions in the literature by examining the sources and effects of co‐movements in CEO incentives, whether the proportionality of these movements is rationally priced, and whether the effects are concentrated among bonds with greater likelihood of default. Our findings confirm that effort and risk incentives are rationally priced by bond market participants. We also show that significant cross‐sectional effects are more pronounced for speculative bonds, implying that previously documented links between equity incentives and the cost of debt may not be generalizable to all debt issues.     

Momentum spillover from stocks to corporate bonds

We investigate and improve momentum spillover from stocks to corporate bonds, i.e. the phenomenon that past winners in the equity market are future winners in the corporate bond market. We find that a momentum spillover strategy exhibits strong structural and time-varying default risk exposures that cause a drag on the profitability of the strategy and lead to large drawdowns if the market cycle turns from a bear to a bull market. By ranking companies on their firm-specific equity return, instead of their total equity return, the default risk exposures halve, the Sharpe ratio doubles and the drawdowns are substantially reduced.     

DEFAULT RISK PREMIA IN THE NEAR-CASH INVESTMENT MARKET: THE CASE OF AUCTION RATE PREFERRED STOCK VERSUS COMMERCIAL PAPER

Auction rate preferred stock (ARPS) is often regarded as an alternative to other near-cash instruments such as commercial paper while the dividend exclusion for ARPS offers tax advantages to corporate purchasers. The mean default risk premium for ARPS, relative to commercial paper, is estimated at 83 basis points during stable financial markets. This default premium appears to surge during unstable equity markets, having jumped by 192 basis points in November 1987. Lower-rated ARPS shows even larger changes, with yields 40–50 basis points above yields on high-rated ARPS, adjusted for the normal risk premium differential. The perceived risk change of ARPS underscores how quickly market participants re-evaluate default risk, and even the importance of the priority order among debt and equity claimants. Findings suggest ARPS and commercial paper are not an acceptable substitute for commercial paper during times of unsettled equity markets.     

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short‐selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short‐sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive‐net‐supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.