Pricing Defaultable Bonds Using a Lévy Jump‐Diffusion Model

This paper uses a reduced‐form approach to derive a closed‐form pricing formula for defaultable bonds. The authors specify the default hazard rate as an affine function of multiple variables which follow the Lévy jump‐diffusion processes. Because such specification allows greater flexibility in the generation of a valid probability of default, their pricing model should be more accurate than the valuation models in traditional studies, which ignore the jump effects. This paper also proposes a new method for estimating the parameters in a Lévy Jump‐diffusion process. The real data from the Taiwanese bond market are used to illustrate how their model can be applied in practical situations. The authors compare the pricing results for the influential variables with no jump effects, with jump magnitudes following the normal distribution, and with jump magnitudes following the gamma distribution. The results reveal that the predictive ability is the best for the model with the jump components. The valuation model shown in this paper should help portfolio managers more accurately price defaultable bonds and more effectively hedge their portfolio holdings.     

Long-duration bonds and sovereign defaults

This paper extends the baseline framework used in recent quantitative studies of sovereign default by assuming that the government can borrow using long-duration bonds. This contrasts with previous studies, which assume the government can borrow using bonds that mature after one quarter. We show that, when we assume that the government issues bonds with a duration similar to the average duration of sovereign bonds in emerging economies, the model generates an interest rate that is substantially higher and more volatile than the one obtained assuming one-quarter bonds. This narrows the gap between the predictions of the model and the data, which indicates that the introduction of long-duration bonds may be a useful tool for future research about emerging economies. Our analysis is also relevant for the study of other credit markets.     

Defaultable debt, interest rates and the current account

World capital markets have experienced large scale sovereign defaults on a number of occasions. In this paper we develop a quantitative model of debt and default in a small open economy. We use this model to match four empirical regularities regarding emerging markets: defaults occur in equilibrium, interest rates are countercyclical, net exports are countercyclical, and interest rates and the current account are positively correlated. We highlight the role of the stochastic trend in emerging markets, in an otherwise standard model with endogenous default, to match these facts.     

Value investing in emerging markets: risks and benefits

This paper identifies a subset of emerging markets that have higher than average expected returns and studies risk properties of this subset by investment simulations. It is found that: (1) the portfolio of ‘value’ emerging markets generates superior returns; and (2) statistical measures of its risk are close to the corresponding measures for the portfolio of all emerging markets. The statistical significance of these results has been checked by a bootstrap procedure. The results imply that the optimal share of emerging markets increases from 0% for an equally weighted portfolio to approximately 25% for the portfolio of undervalued emerging markets.     

Bond yields in emerging economies: It matters what state you are in

While many studies have looked into the determinants of yields on externally issued sovereign bonds of emerging economies, analysis of domestically issued bonds has hitherto been limited, despite their growing relevance. This paper finds that the extent to which fiscal variables affect domestic bond yields in emerging economies depends on the level of global risk aversion. During tranquil times in global markets, fiscal variables do not seem to be a significant determinant of domestic bond yields in emerging economies. However, when market participants are on edge, they pay more attention to country-specific fiscal fundamentals, revealing greater alertness about default risk.     

Sovereign defaults and liquidity crises

Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises. The conventional view is that the domestic turmoil is the consequence of foreign retaliation, although there is no clear empirical evidence on “classic” default penalties. This paper emphasizes, instead, a direct link between sovereign defaults and liquidity crises building on two natural assumptions: (i) government bonds represent a source of liquidity for the domestic private sector and (ii) the government cannot discriminate between domestic and foreign creditors in the event of default. In this context, external debt emerges even in the absence of classic penalties, and government default is countercyclical, triggers a liquidity crunch, and amplifies output volatility. In addition, a reform that involves a substitution of government bonds with privately-sourced liquidity instruments could backfire by restricting governments' access to foreign credit.     

Regime switching in the reactions of stock markets in Saudi Arabia to oil price variations

The study revisits the stock–oil nexus by examining the reactions of equity markets to oil price shocks at national and sectoral levels for Saudi Arabia in a time‐varying framework by employing the Markov switching EGARCH model developed by Henry (2009, Journal of Banking and Finance, 33, 405). Based on weekly data, the findings reveal that the behaviour of all stock markets switches between an expansion regime and a recession regime, with more persistence for the expansion state. Additionally, influential international events associated with stock market drops are clearly identified in the recession regime. Furthermore, there is evidence of asymmetric reactions of the equity index returns and the probabilities of transition from one state to another to oil price variations, with heterogeneous impacts across sectors and regimes. The stock markets are more sensitive to oil price decreases than to oil price increases. Although the evidence of relatively slight differences in some findings across weekdays, the study allows investors and policymakers to understand well the interactions of stock sector markets vis‐à‐vis the world oil market in a regime‐switching framework, in order to make the right decision as regards portfolio diversification and regulation of the stock markets.     

Including emerging markets in international momentum investment strategies

Momentum return investment strategies that diversify across countries provide lower portfolio standard deviations and/or increased expected returns. These diversification benefits are larger when adding emerging markets than when adding developed markets, and they are larger than would be suggested by diversifying with long-only portfolios. Using data on almost 16,000 firms from 22 developed and 18 emerging markets over the 1990–2004 period, we confirm the profitability of momentum trading strategies in both developed and emerging markets and document the diversification benefits of including emerging markets in an international momentum portfolio investment strategy.     

商业银行贷款组合的风险控制研究

商业银行经营管理的核心是收益与风险的权衡,对贷款进行组合多样化管理,可以达到分散风险的目的,而单项贷款违约模型的确定是贷款组合多样化的基础。本文基于期权模型讨论了商业银行的贷款组合问题,认为在商业银行贷款管理中引入期权概念,可以定量地利用成熟的期权理论进行分析研究,为多样化分析提供较为准确的量度方法。     

OPTIMAL INVESTMENT IN CREDIT DERIVATIVES PORTFOLIO UNDER CONTAGION RISK

We consider the optimal portfolio problem of a power investor who wishes to allocate her wealth between several credit default swaps (CDSs) and a money market account. We model contagion risk among the reference entities in the portfolio using a reduced‐form Markovian model with interacting default intensities. Using the dynamic programming principle, we establish a lattice dependence structure between the Hamilton‐Jacobi‐Bellman equations associated with the default states of the portfolio. We show existence and uniqueness of a classical solution to each equation and characterize them in terms of solutions to inhomogeneous Bernoulli type ordinary differential equations. We provide a precise characterization for the directionality of the CDS investment strategy and perform a numerical analysis to assess the impact of default contagion. We find that the increased intensity triggered by default of a very risky entity strongly impacts size and directionality of the investor strategy. Such findings outline the key role played by default contagion when investing in portfolios subject to multiple sources of default risk.     

Sovereign borrowing by developing countries: What determines market access?

What determines the ability of governments from developing countries to access international credit markets? We examine this question using detailed data on sovereign bond issuances and public syndicated bank loans between 1980 and 2000. A key finding of this paper is that the probability of market access is not influenced by a country's frequency of defaults, and that a default, if resolved quickly, does not reduce significantly the probability of tapping the markets. We also find that trade openness, a standard measure of a country's links with the rest of the world, and traditional liquidity and macroeconomic indicators do not help much in explaining market access. However, a country's vulnerability to shocks and the perceived quality of economic policies and institutions appear to influence the government's ability to tap the markets. We also document that the average exclusion from international credit markets following a default declined from four years in the 1980s to two years in the 1990s.     

What explains default risk premium during the financial crisis? Evidence from Japan

As is well documented, subprime mortgage markets carried significant default risk. This paper investigates the relationship between default risk premium, stock market conditions and macroeconomic variables during the financial crisis. Using iTraxx Japan Credit Default Swap (CDS) index spreads covering the period from March 2006 to November 2009, we employ a time-varying dynamic factor model with Markov regime switching to generate regime probabilities for default risk. We analyze the sensitivity of default risk premium changes to stock market conditions and macroeconomic variables by using two-state Markov switching models: a crisis regime sparked by rising loan defaults in the sub-prime mortgage market, and a non-crisis regime. We found strong evidence that the relationship between default risk premium changes, stock market and macroeconomic variables is regime-dependent. Our results suggest that during periods of crisis, CDS indices behave as a higher-risk indicator and become more sensitive to stock market conditions and macroeconomic variables. This paper examines the effects of the financial crisis in explaining the default risk premium. Understanding the determinants of default risk premium is important for financial analysts, economic policy makers and credit risk management.     

A down-and-out exchange option model with jumps to evaluate firms' default probabilities in Brazil

We develop a tractable structural model to estimate a firm's default probability by modeling its asset and debt behavior. The model incorporates jump factors. For a set of Brazilian large corporations, we compare the structural model results to the default probabilities predicted by a survival analysis applied to the Central Bank debt information database. Our model outperforms other structural models. In a last step, we use a firm's sector failure probabilities to calibrate the model. This process is executed by adjusting the model jump volatility and it helps to explain the differences between debt and equity market failure probabilities.     

The nature and determinants of comovement between developed,emerging and frontier equity markets: Europe versus Asia‐Pacific

International investors are increasingly attracted towards emerging and frontier markets because of their potential to enhance diversification benefits of a global portfolio. This calls for a rigorous analysis of the nature and determinants of stock market comovement between developed, emerging, and frontier markets in Europe and Asia‐Pacific regions. The findings suggest that unlike their Asia‐Pacific counterparts, European developed, emerging, and frontier stock markets display a higher degree of comovement. Although Asia‐Pacific frontier markets provide good diversification opportunities, investors must be cautioned against their weak financial system. The volatility of returns, gross domestic product growth rate, and the 2008 global financial crisis (GFC) are the key determinants of stock market comovement in Europe. The mechanisms by which comovement in the Asia‐Pacific region is strengthened differ across markets. Comparative analysis of comovement and its determinants across different classes of equity markets and geographies is expected to provide valuable perspectives to global investors, portfolio managers, and policymakers.     

Does socially responsible investment equity indexes in emerging markets pay off? Evidence from Brazil

This paper explores the financial performance of a mainstream socially responsible investment equity index in emerging markets: the Brazilian Corporate Sustainability Index. The results indicate that investors in emerging markets could accommodate their ethical values while at the same time not scarifying their overall portfolio performance in bullish market periods. However, the financial crisis led ethical investors to take a riskier and less profitable portfolio. These results seem to be due to socially responsible investment in Brazil that, as with other emerging markets, is highly influenced by social and institutional factors.     

Estimation of the default risk of publicly traded companies: evidence from Canadian data

Through Canadian publicly traded companies, this study assessed how combining firms' continuous valuations by the market (structural model) with the value given in their financial statements (accounting model) could enhance prediction of a company's probability of default. The hybrid model outperformed other models. Specifically, estimated structural probabilities of default (PDs) contributed significantly to predicting default probabilities when they were included alongside accounting and macroeconomic variables in our hybrid model. These results were obtained with two versions of the structural model: the Merton model (Merton, 1973, 1974) and the default barrier model (Brockman & Turtle, 2003). Both models were estimated with the maximum likelihood method. Copyright © 2008 ASAC. Published by John Wiley & Sons, Ltd.     

Sovereign default and debt renegotiation

This paper develops a small open economy model to study sovereign default and debt renegotiation for emerging economies. The model features both endogenous default and endogenous debt recovery rates. Sovereign bonds are priced to compensate creditors for the risk of default and the risk of debt restructuring. The model captures the interaction between sovereign default and ex post debt renegotiation. We find that both debt recovery rates and sovereign bond prices decrease with the level of debt. In a quantitative analysis, the model accounts for the debt reduction, volatile and countercyclical bond spreads, countercyclical trade balance, and other empirical regularities of the Argentine economy. The model also replicates the dynamics of bond spreads during the debt crisis in Argentina.     

Credit Risk Assessment and Relationship Lending: An Empirical Analysis of German Small and Medium‐Sized Enterprises*

We estimate a logit scoring model for the prediction of the probability of default by German small and medium‐sized enterprises (SMEs) using a unique data set on SME loans in Germany. Our scoring model helps SMEs to gain knowledge about their default risk, which can be used to approximate their risk adequate cost of debt. This knowledge is likely to lead to a detection of hold‐up problems that German SMEs might be confronted with in their bank relationships. Furthermore, it allows them to monitor their bank’s pricing behavior and it reduces information asymmetries between lenders and borrowers. Finally, it can influence their future financing decisions toward capital market‐based financing.     

Turnover and return in global stock markets

I study how growth affects liquidity of global stock exchanges and how liquidity determines cross-sectional returns on those stock exchange index portfolios. I measure portfolio liquidity by turnover ratio computed as value of shares traded over the market capitalization. I obtain data from FIBV, an association of global stock exchanges. In a multiple regression model for turnover ratio, I find age, size, type of exchange, competition for order flow, and growth rate to be significant determinants of portfolio liquidity; however, exchange- and time-specific effects are more appropriate for modeling portfolio liquidity. The time effects yield to three distinct regimes, while the exchange-specific effects are surrogates for the legal systems, English common law, and Civil laws of the countries. I estimate the parameters of a multiple regression model in a two-stage GLS framework in which index return is a function of turnover. The GLS method is preferable since a turnover ratio may have a non-stationary, random component. The significant determinants of index return are turnover and volatility, although some of the volatility effect may be a spillover from a January effect. Investors expect higher return from high turnover markets. However, the positive turnover expected return relation is true only in emerging markets; in developed markets expected return is a function of volatility. This result confirms existing empirical evidence that high turnover stock portfolios generate superior returns and further the sources and pricing of risk in emerging and developed markets are different.     

SENSITIVITY ANALYSIS OF NONLINEAR BEHAVIOR WITH DISTORTED PROBABILITY

In this paper, we propose a sensitivity‐based analysis to study the nonlinear behavior under nonexpected utility with probability distortions (or “distorted utility” for short). We first discover the “monolinearity” of distorted utility, which means that after properly changing the underlying probability measure, distorted utility becomes locally linear in probabilities, and the derivative of distorted utility is simply an expectation of the sample path derivative under the new measure. From the monolinearity property, simulation algorithms for estimating the derivative of distorted utility can be developed, leading to gradient‐based search algorithms for the optimum of distorted utility. We then apply the sensitivity‐based approach to the portfolio selection problem under distorted utility with complete and incomplete markets. For the complete markets case, the first‐order condition is derived and optimal wealth deduced. For the incomplete markets case, a dual characterization of optimal policies is provided; a solvable incomplete market example with unhedgeable interest rate risk is also presented. We expect this sensitivity‐based approach to be generally applicable to optimization problems involving probability distortions.