Habit formation,the cross section of stock returns and the cash-flow risk puzzle

Non-linear external habit persistence models, which feature prominently in the recent “equity premium” asset pricing and macroeconomics literature, generate counterfactual predictions in the cross-section of stock returns. In particular, we show that in the absence of cross-sectional heterogeneity in firms’ cash-flow risk, these models produce a “growth premium,” that is, stocks with high price-to-fundamental ratios command a higher premium than stocks with low price-to-fundamental ratios. This implication is at odds with the well-established empirical observation of a “value premium” in the cross-section of stock returns. Substantial heterogeneity in firms’ cash-flow risk yields both a value premium as well as most of the stylized facts about the cross-section of stock returns, but it generates a “cash-flow risk puzzle”: Quantitatively, value stocks have to have “too much” cash-flow risk compared to the data to generate empirically plausible value premiums.     

Valuation of vulnerable American options with correlated credit risk

This article evaluates vulnerable American options based on the two-point Geske and Johnson method. In accordance with the Martingale approach, we provide analytical pricing formulas for European and multi-exercisable options under risk-neutral measures. Employing Richardson’s extrapolation gets the values of vulnerable American options. To demonstrate the accuracy of our proposed method, we use numerical examples to compare the values of vulnerable American options from our proposed method with the benchmark values from the least-square Monte Carlo simulation method. We also perform sensitivity analyses for vulnerable American options and show how the prices of vulnerable American options vary with the correlation between the underlying assets and the option writer’s assets.      

Growth to value: Option exercise and the cross section of equity returns

We propose a general equilibrium model to study the link between the cross section of expected returns and book-to-market characteristics. We model two primitive assets: value assets and growth assets that are options on assets in place. The cost of option exercise, which is endogenously determined in equilibrium, is highly procyclical and acts as a hedge against risks in assets in place. Consequently, growth options are less risky than value assets, and the model features a value premium. Our model incorporates long-run risks in aggregate consumption and replicates the empirical failure of the conditional capital asset pricing model (CAPM) prediction. The model also quantitatively accounts for the pattern in mean returns on book-to-market sorted portfolios, the magnitude of the CAPM-alphas, and other stylized features of the cross-sectional data.     

Exploring the components of credit risk in credit default swaps

In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.     

Accounting data and the credit spread: An empirical investigation

Measures of credit risk based on Merton (1974) rely upon information available in the market prices of securities. Under the Efficient Market Hypothesis market prices should reflect all available information and, hence, make redundant all other information in the analysis of credit risk. This paper examines whether accounting data are fully reflected in the market-based measures of credit risk and therefore has no role in explaining variations in the credit spread on corporate bonds. We use a sample consisting of over 11,000 firm-quarter observations with matched equity, bond and accounting data. The results suggest that equity volatility and Merton's distance-to-default outperform accounting variables in explaining variations in the credit spread. However, accounting variables are incrementally informative in explaining variations in the credit spread when considered in conjunction with market-based measures. Within the set of accounting variables considered, we find that the profitability ratio is by far the most incrementally informative accounting variable.     

On the calibration of structural credit spread models

Empirical findings are mixed about the performance of structural models for term structure of credit spreads. It is commonly believed that all structural models have equally poor performance after calibration. However, proper calibration is not a trivial issue, especially for highly structural models. This paper proposes a more accurate procedure for calibrating two models: Leland–Toft (J Finance 51:987–1019, 1996) and Collin-Dufresne and Goldstein (J Finance 56:2177–2208, 2001). Using rating-based bond data, we find that the Leland–Toft model has significantly greater explanatory power for credit spreads across rating categories than previously reported. We provide theoretical explanations for these findings, and further extend our empirical analysis to include 286 individual senior bonds. Our findings help clarify the controversies over the performance of structural models in general and that of the Leland–Toft model in particular. In addition, we offer a rigorous procedure that can be used for calibrating other structural models more effectively.      

Investment,idiosyncratic risk,and growth options

We provide evidence that growth options play an important role in determining the negative relation between corporate investment and idiosyncratic risk in the absence of agency problem. A simple real options model predicts that the negative relation between corporate investment and idiosyncratic risk is a U-shaped function of the level of idiosyncratic risk: investment responds the most when idiosyncratic risk is at the intermediate level. And the negative relation is stronger when firms possess more growth options. Our results are robust when we control for the effect of managerial risk aversion, supporting the view that firms’ optimal response to uncertainty is an important driving force behind the negative investment–idiosyncratic risk relation.     

Capital structure,credit risk,and macroeconomic conditions

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.     

Seeking causality between liquidity risk and credit risk: TED-OIS spreads and CDS indexes

Since the Global Financial Crisis, credit risk and its management have become one of the most appealing topics in finance literature. In this study, we investigate the interaction of credit risk and liquidity risk through the TED and the OIS spreads and various credit default swap indexes from the CDX and the iTraxx family (CDXIG, CDXHY, ITEEU, and ITEXO). The empirical analysis is conducted through the Kapetanios unit root test, the EGARCH model, the Bootstrap Toda-Yamamoto modified Wald test and the asymmetric causality analysis. The results of symmetric and asymmetric causality methods reveal that liquidity risk appears to play an important role in credit risk, and in most cases, the TED and the OIS spreads dominate the CDS indexes. It can, thus, be concluded that the TED and the OIS spreads are superior to the CDS indexes as an early warning indicator in the credit market.     

Impact of macroeconomic announcements on implied volatility slope of SPX options and VIX

This paper examines the impact of macroeconomic announcements on the high-frequency behavior of the observed implied volatility skew of S&P 500 index options and VIX. We document that macroeconomic announcements affect VIX significantly and slope at a lesser extent. We also find evidence that good and bad announcements significantly and asymmetrically change implied volatility slope and VIX.     

Counterparty credit risk and the credit default swap market

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers' credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.     

Understanding the price of volatility risk in carry trades

This paper investigates the cross-sectional pricing ability of the short- and long-run components of global foreign exchange (FX) volatility for carry trade returns. We find a negative and statistically significant factor risk price for the long-run component, but no significant pricing effect due to the short-run volatility component. We also document that the dynamics of the long-run component of global FX volatility are related to US macroeconomic fundamentals. Our results are robust to various parametrizations of the volatility models used to obtain the volatility components and they are invariant to alternative asset pricing testing methodologies and sample periods.     

Stock options and capital structure

We show that value-maximizing CEOs compensated with stock options prefer debt to equity. Our pecking order result does not depend on managerial risk aversion, managerial firm-specific human capital, or asymmetric information. Moreover, our result holds at least weakly regardless of the distribution of firm cash flows and strictly as long as the support of the cash flow distribution is big enough to bring all features of the stock option contract into play with positive probability JEL Classification Numbers: G0, G3 An earlier version of this paper was completed while Page was visiting CERMSEM at Paris 1 and the University of Warwick. Page gratefully acknowledges the support and hospitality of CERMSEM, Paris 1 and Warwick. Page also gratefully acknowledges financial support from the Department of Economics, Finance, and Legal Studies and the Culverhouse College of Business at the University of Alabama. Both authors are grateful to seminar participants in the Financial Markets Group Workshop at LSE for many helpful comments and both authors are especially grateful to an anonymous referee whose detailed and insightful comments led to substantial improvements in the paper     

Valuation of American options in the presence of event risk

This paper studies the valuation of American options in the presence of external/non-hedgeable event risk. When the event occurs, the American option is terminated and a rebate is paid instead of the promised pay-off profile. Consequently, the presence of event risk influences the exercise strategy of the option holder. For the financial market in a diffusion setting, the probabilistic structure in terms of equivalent martingale measures is briefly analysed. Then, for a given equivalent martingale measure the optimal stopping problem of the American option is solved. As a main result, no-arbitrage bounds for American option values in the presence of event risk are derived, as well as hedging strategies corresponding to the no-arbitrage bounds.Received: May 2004, Mathematics Subject Classification: 90C47, 60H30, 60G40JEL Classification: G13, D52, D81The author thanks John Gould and Ross Maller for useful discussions. The author is also grateful to a referee for helpful comments. This research was partially supported by University of Western Australia Research Grant RA/1/485.     

Optimal credit risk transfer, monitored finance, and banks

We examine the implications of optimal credit risk transfer (CRT) for bank-loan monitoring, and the incentives for banks to engage in optimal CRT. In our model, properly designed CRT instruments allow banks to insure themselves against loan losses precisely in those states that signal monitoring. We find that optimal CRT enhances loan monitoring and expands financial intermediation, in contrast to the findings of the previous literature. Optimal CRT instruments are based on loan portfolios rather than individual loans and have credit-enhancement guarantees, pretty much as banks do in practice. But the extent of credit enhancement needs to be precisely delimited. Above that exact level, monitoring incentives are undermined (loan quality deteriorates) and wealth is transferred from the bank's financiers to the bank. Properly designed risk-based capital requirements are shown to prevent such a wealth transfer and to provide banks with the incentive to engage in optimal CRT.     

Leverage, options liabilities, and corporate bond pricing

The two major problems with typical structural models are the failure to attain a positive credit spread in the very short term, and overestimation of the overall level of the credit spread. We recognize the presence of option liabilities in a firm’s capital structure and the effect they have on the firm’s credit spread. Including option liabilities and employing a regime switching interest rate process to capture the business cycle resolves the above-mentioned drawbacks in explaining credit spreads. We find that the credit spread overestimation problem in one of the structural models, Collin-Dufresne and Goldstein (J Finan 56:1929–1957, 2001), can be resolved by combining option liabilities and the regime-switching interest rate process when dealing with an investment grade bond, whereas with junk bonds, only the regime-switching interest rate process is needed. We also examine vulnerable option values, debt values, and zero-coupon bond values with different model settings and leverage ratios.      

Distress Risk,Growth and Earnings Quality

We extend and complement prior work by investigating the earnings quality of firms with different financial health characteristics and growth prospects. By using three alternative measures of default likelihood and two alternative measures of growth options, without being limited to a specific event, we provide a more comprehensive setup for analysing the earnings characteristics of the universe of firms than examining distressed firms with persistent losses, dividend reductions or bankruptcy‐filings. Our dataset consists of 15,049 healthy U.S. firms over the period 1990–2004. Results show that the relation between earnings quality and financial health is not monotonic. Distressed firms have a low level of earnings timeliness for bad news and a high level for good news, and manage earnings toward a positive target more frequently than healthy firms. On the other hand, healthy firms have a high level of earnings timeliness for bad news. Growth aspects play an important role in a firm's ability to manage earnings. In contrast to the findings of prior studies, growth firms have greater earnings timeliness for bad news, whereas value firms manage earnings toward a positive target more frequently than growth firms.     

金融发展、边界资本配置与经济增长

传统金融发展理论认为,金融发展以提高社会资本配置效率促进经济增长。但 是,该理论忽略了国民经济需要产业部门协调发展的事实,使得央行的结构信贷政策受到质 疑。本文针对这一理论缺陷提出“边界资本配置效率”的概念,并通过实证研究发现：我国金 融发展对经济增长的促进作用,不仅表现在总量上,而且表现在结构上,即央行的结构信贷政 策整体有效。上述结论有助于央行完善实施定向降准政策的商业银行筛选标准。