Internal liquidity risk,financial bullwhip effects,and corporate bond yield spreads: Supply chain perspectives

This study explores internal liquidity risk (ILR) and financial bullwhip effects on corporate bond yield spreads along supply chain counterparties by employing American market data from year 1997 to 2008. This study finds that the ILRs of suppliers and customers positively affect a firm’s bond yield spreads and the effects of customers’ ILRs are greater. This research also finds a financial bullwhip effect that the ILR effect becomes greater upwardly along the supply chain counterparties. The results are robust when controlling for well-known spread determinant variables.     

Credit market shocks and economic fluctuations: Evidence from corporate bond and stock markets

To identify disruptions in credit markets, research on the role of asset prices in economic fluctuations has focused on the information content of various corporate credit spreads. We re-examine this evidence using a broad array of credit spreads constructed directly from the secondary bond prices on outstanding senior unsecured debt issued by a large panel of nonfinancial firms. An advantage of our “ground-up” approach is that we are able to construct matched portfolios of equity returns, which allows us to examine the information content of bond spreads that is orthogonal to the information contained in stock prices of the same set of firms, as well as in macroeconomic variables measuring economic activity, inflation, interest rates, and other financial indicators. Our portfolio-based bond spreads contain substantial predictive power for economic activity and outperform—especially at longer horizons—standard default-risk indicators. Much of the predictive power of bond spreads for economic activity is embedded in securities issued by intermediate-risk rather than high-risk firms. According to impulse responses from a structural factor-augmented vector autoregression, unexpected increases in bond spreads cause large and persistent contractions in economic activity. Indeed, shocks emanating from the corporate bond market account for more than 30 percent of the forecast error variance in economic activity at the two- to four-year horizon. Overall, our results imply that credit market shocks have contributed significantly to US economic fluctuations during the 1990-2008 period.     

Option-implied volatility factors and the cross-section of market risk premia

The main goal of this paper is to study the cross-sectional pricing of market volatility. The paper proposes that the market return, diffusion volatility, and jump volatility are fundamental factors that change the investors’ investment opportunity set. Based on estimates of diffusion and jump volatility factors using an enriched dataset including S&P 500 index returns, index options, and VIX, the paper finds negative market prices for volatility factors in the cross-section of stock returns. The findings are consistent with risk-based interpretations of value and size premia and indicate that the value effect is mainly related to the persistent diffusion volatility factor, whereas the size effect is associated with both the diffusion volatility factor and the jump volatility factor. The paper also finds that the use of market index data alone may yield counter-intuitive results.     

Money and liquidity in financial markets

We argue that there is a connection between the interbank market for liquidity and the broader financial markets, which has its basis in demand for liquidity by banks. Tightness in the market for liquidity leads banks to engage in what we term “liquidity pull-back,” which involves selling financial assets either by banks directly or by levered investors. Empirical tests on the stock market are supportive. Tighter interbank markets are associated with relatively more volume in more liquid stocks; selling pressure, especially in more liquid stocks; and transitory negative returns. We control for market-wide uncertainty and in the process also contribute to the literature on portfolio rebalancing. Our general point is that money matters in financial markets.     

Tracking down distress risk

This paper shows that exposure to aggregate distress risk is the underlying source of the premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique data set of aggregate business failures of both private and public firms from 1926 to 1997, I build portfolios that track news about future firm failures. These tracking portfolios optimally hedge aggregate distress risk and earn a Capital Asset Pricing Model (CAPM) alpha of approximately −4% a year. Both HML and SMB predict changes in future failure rates. Small stocks have lower returns than large stocks and value stocks have lower returns than growth stocks when the market expects an increase in future failure rates. Finally, a two-factor model with the market and the tracking portfolio for aggregate distress as factors does as well as the Fama-French three-factor model in pricing the 25 size and book-to-market sorted portfolios.     

Omitted debt risk, financial distress and the cross-section of expected equity returns

The study of Ferguson and Shockley (2003) shows that, if the Merton (1974) model can reflect reality, the omission of debt claims from the market portfolio proxy may explain the poor pricing ability of the CAPM in empirical tests. We critically re-assess this argument by first reviewing existing, but also new avenues through which the Merton (1974) model can point to a systematic bias in market beta estimates. However, we also show that some avenues are diversifiable, and that they all rely on excessive economy-wide default risk to create a non-negligible bias. We then use the Merton (1974) model to proxy for the total debt portfolio, but find that its application in empirical tests cannot improve pricing performance. We conclude that there are (so far) no valid theoretical reasons to believe that omitted debt claims undermine CAPM tests.     

Asset market linkages: Evidence from financial, commodity and real estate assets

We use a general Markov switching model to examine the relationships between returns over three different asset classes: financial assets (US stocks and Treasury bonds), commodities (oil and gold) and real estate assets (US Case-Shiller index). We confirm the existence of two distinct regimes: a “tranquil” regime with periods of economic expansion and a “crisis” regime with periods of economic decline. The tranquil regime is characterized by lower volatility and significantly positive stock returns. During these periods, there is also evidence of a flight from quality - from gold to stocks. By contrast, the crisis regime is characterized by higher volatility and sharply negative stock returns, along with evidence of contagion between stocks, oil and real estate. Furthermore, during these periods, there is strong evidence of a flight to quality - from stocks to Treasury bonds.     

Volatility risk and the value premium: Evidence from the French stock market

This paper documents that systematic volatility risk is an important factor that drives the value premium observed in the French stock market. Using returns on at-the-money straddles written on the CAC 40 index as a proxy for systematic volatility risk, I document significant differences between volatility factor loadings of value and growth stocks. Furthermore, when markets are classified into expected booms and recessions, volatility factor loadings are also time-varying. When expected market risk premium is above its average, i.e. during expected recessions, value stocks are seen riskier than their growth counterparts. This implies in bad times, investors shift their preferences away from value firms. Instead they use growth stocks as hedges against deteriorations in their wealth during those times. The findings are in line with the predictions of rational asset pricing theory and support a “flight-to-quality” explanation.     

Oil price dynamics,macro-finance interactions and the role of financial speculation

What is the role of financial speculation in determining the real oil price? We find that while macroeconomic shocks have been the main real oil price upward driver since mid-1980s, financial shocks have sizably contributed since early 2000s as well, and at a much larger extent since mid-2000s. Even though financial shocks contribute 44% out of the 65% real oil price increase over the period 2004–2010, the third oil price shock is a macro-finance episode: macroeconomic shocks actually largely account for the 2007–2008 oil price swing. While we then find support to the demand side view of real oil price determination, we however also find a much larger role for financial shocks than previously noted in the literature.     

Expected returns, risk premia, and volatility surfaces implicit in option market prices

This article presents a pure exchange economy that extends Rubinstein (1976) to show how the jump-diffusion option pricing model of Merton (1976) is altered when jumps are correlated with diffusive risks. A non-zero correlation between jumps and diffusive risks is necessary in order to resolve the positively sloped implied volatility term structure inherent in traditional jump diffusion models. Our evidence is consistent with a negative covariance, producing a non-monotonic term structure. For the proposed market structure, we present a closed form asset pricing model that depends on the factors of the traditional jump-diffusion models, and on both the covariance of the diffusive pricing kernel with price jumps and the covariance of the jumps of the pricing kernel with the diffusive price. We present statistical evidence that these covariances are positive. For our model the expected stock return, jump and diffusive risk premiums are non-linear functions of time.     

Stock market bubbles, inflation and investment risk

This paper proposes an autoregressive regime-switching model of stock price dynamics in which the process creates pricing bubbles in one regime while error-correction prevails in the other. In the bubble regime the stock price depends negatively on inflation. In the error-correction regime it depends on the price-dividend ratio. We find that the probability of regime-switch depends on exogenous inflation and lagged price. The model is consistent with Shleifer and Vishny's theoretical noise trader and arbitrageur model and Modigliani's inflation illusion phenomenon. The results emphasize the importance of inflation and the price-dividend ratio when assessing investment risk.     

Stock market reaction to fed funds rate surprises: State dependence and the financial crisis

This paper examines the response of US stock returns to Federal Funds rate (FFR) surprises between 1989 and 2012, focusing on the impact of the recent financial crisis. We find that outside the crisis period, stock prices increased as a response to unexpected FFR cuts. State dependence is identified with stocks exhibiting larger increases when interest rate easing coincided with recessions, bear markets, and tightening credit conditions. However, an important structural shift occurred during the crisis, changing the stocks’ response to FFR shocks and the nature of state dependence. Throughout the crisis period, stocks did not react positively to unexpected FFR cuts, which were interpreted as signals of worsening future economic conditions. This triggered a rebalancing of investment portfolios away from falling equities and towards safe-haven assets. Our results highlight the severity of the crisis and the ineffectiveness of conventional monetary policy close to the zero lower bound.     

The response of the external finance premium in Asian corporate bond markets to financial characteristics,financial constraints and two financial crises

Empirical investigation of the external finance premium has been conducted on the margin between internal finance and bank borrowing or equities but little attention has been given to corporate bonds, especially for the emerging Asian market. In this paper, we hypothesize that balance sheet indicators of creditworthiness could affect the external finance premium for bonds as they do for premia in other markets. Using bond-specific and firm-specific data for China, Hong Kong, Indonesia, Korea, Philippines, Singapore and Thailand during 1995–2009 we find that firms with better financial health face lower external finance premia in all countries. When we introduce firm-level heterogeneity, we show that financial variables appear to be both statistically and quantitatively more important for financially constrained firms. Finally, when we examine the effects of the 1997–1998 Asian crisis and the 2007–2009 global financial crisis, we find that the sensitivity of the premium is greater for constrained firms during the Asian crisis compared to other times.     

Neglected risks,financial innovation,and financial fragility

We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.     

Firm-specific risk and equity market development

We show that the increase in firm-specific risk in the US stock market is the result of new listings by riskier companies. In addition, our results explain why prior researchers have found that growth opportunities, profit margin, firm size, and industry composition (among other factors) are related to increases in firm-specific risk. The new listing effect is not driven by small companies becoming riskier but instead by a riskier sub-sample of the economy becoming publicly traded. These results are consistent with prior research that documents time trends in financial market development.     

Testing for negative expected market return premia

This paper tests the hypothesis that the expected return premium on the market portfolio is always non-negative. A violation of this lower bound restriction provides evidence against a broad class of risk-based equilibrium models in favor of bubble behavior. Our tests utilize information variables, identified in prior literature, that predict time variation in market return premia. We employ out-of-sample forecasts and bootstraps generated with parameters that are consistent with non-negativity but closest to the estimated parameters. We find statistically reliable evidence against non-negativity for the excess return on the value-weighted market index. The most negative out-of-sample prediction was −2.01% in September 1973.     

Product market competition and credit risk

This study theoretically and empirically investigates effects of product market competition on credit risk. We first develop a real-options-based structural model in a homogeneous oligopoly and show that credit spreads are positively related to the number of firms in an industry. The disparity of firm size in an industry is relevant to both product market competition and credit risk, and we therefore extend the model to an asymmetric duopoly case. In particular, we demonstrate that credit spreads of relatively small (large) firms within an industry are positively (negatively) related to Herfindahl-Hirschman index, and the relative firm size in an industry is an important determinant of credit risk. The models’ implications are empirically scrutinized by a reduced-form hazard model and generally supported. By performing out-of-sample analyses, the results demonstrate that firm size together with the interaction terms between intra-industry firm size dummies and competition intensity can effectively predict default.     

Credit conditions and recoveries from financial crises

Recoveries from recessions associated with a financial crisis tend to be sluggish. In this paper, we present evidence that stressed credit conditions are an important factor constraining the pace of recovery. In particular, using industry-level data, we find that industries relying more on external finance grow more slowly than other industries during recoveries from recessions associated with financial crises. Additional tests, based on establishment size, on alternative definitions of financial crises, and on corporate-government interest rate spreads, support the findings. Moreover, for subsets of industries where financial frictions are more severe, we find much stronger differential growth effects.     

Interaction of market and credit risk

Experience during the financial crisis illustrates that the integrated measurement and management of different forms of risk remains a challenge for industry practitioners, researchers and financial supervisors alike. In the context of related literature, this article summarizes new research on the interaction of market and credit risk and implications for risk management that is presented in this special issue. The research covered highlights in particular the errors that can occur in the aggregation of the two types of risk and the strong relationships between them that suggest caution in the use of pragmatic distinctions between them. The article also touches on some research-based lessons for supervisory policies and suggests some directions for future research.     

Fiscal policy and financial market movements

This paper estimates fiscal policy reaction function in order to investigate the links between financial market movements and fiscal policy outcomes. An increase in asset prices affects in a positive and significant manner primary balances, with the response reflecting both an increase in government revenues and a fall in government spending. The most important impact on fiscal balances is due to changes in residential property prices. Changes in equity and commercial property prices are also important determinants of fiscal balances. Our findings suggest that the steepening of the slope of the yield curve contributes to expenditure based fiscal discipline.