The role of country-specific fundamentals in sovereign CDS spreads: Eastern European experiences

We investigate the determinants of sovereign CDS spreads on a sample of Eastern European data. A dynamic hierarchical factor model is used to aggregate information in indicators of economic fundamentals. CDS spreads are regressed on forecasts of factors. We find that domestic fundamentals explain more of CDS spread variance than global factors, largely due to their ability to explain differences in sovereign risk across countries. The effects on CDS spreads are found to be time-varying. In terms of economic significance, the factor of institutional-political strength stands out. We apply the model to study CDS spreads of Poland, Russia and Turkey.     

Institutional quality and sovereign credit default swap spreads

We examine how the quality of political, legal, and regulatory institutions impacts sovereign risk premia. An improvement in institutional quality significantly lowers a country's sovereign credit default swap (CDS) spread, even after controlling for domestic and global macroeconomic factors. The incremental effect of institutional quality may also be economically important in explaining the variations in the level of sovereign CDS spreads. The basic results are robust to alternative model specifications, samples, control variables, measures of institutional quality, estimation methods, and controls for endogeneity. Overall, the evidence suggests that institutional quality may play a significant role in explaining sovereign CDS spreads.     

INCORPORATING RISK AND AMBIGUITY AVERSION INTO A HYBRID MODEL OF DEFAULT

It is well known that purely structural models of default cannot explain short‐term credit spreads, while purely intensity‐based models lead to completely unpredictable default events. Here we introduce a hybrid model of default, in which a firm enters a “distressed” state once its nontradable credit worthiness index hits a critical level. The distressed firm then defaults upon the next arrival of a Poisson process. To value defaultable bonds and credit default swaps (CDSs), we introduce the concept of robust indifference pricing. This paradigm incorporates both risk aversion and model uncertainty. In robust indifference pricing, the optimization problem is modified to include optimizing over a set of candidate measures, in addition to optimizing over trading strategies, subject to a measure dependent penalty. Using our model and valuation framework, we derive analytical solutions for bond yields and CDS spreads, and find that while ambiguity aversion plays a similar role to risk aversion, it also has distinct effects. In particular, ambiguity aversion allows for significant short‐term spreads.     

Types of liquidity and limits to arbitrage—the case of credit default swaps

Using a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period June 2008 to September 2009, we show that funding liquidity (shadow cost of capital for arbitrageurs) as well as asset‐specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage‐based parity relationship between the CDS prices and bond yield spreads (CDS‐Bond spread basis). Collectively, our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding‐period of 127 days, but the path to convergence is not smooth. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark     

Are credit spreads too low or too high? A hybrid barrier option approach for financial distress

Based on the works of Brockman, P. and Turtle, H. J. (2003) and Giesecke, K. (2004), we propose in this study a hybrid barrier option model to explain observed credit spreads. It is free of problems with the structural model, which underprescribed credit spreads for investment grade corporate bonds and overprescribed the high‐yield issues. Unlike the standard barrier option approach, our hybrid model does not imply, for high‐yield issues with firms under financial stress, a reduction of credit spreads while firm value actually falls. Our empirical analysis supports that when credit spreads are quoted abnormally higher or rising faster than expected, unexpected changes tend to persist. Otherwise a significant and prompt reversion to long‐term equilibrium takes place. This asymmetric pricing phenomenon is validated with a method introduced by Enders, W. and Granger, C. W. J. (1998) and Enders, W. and Siklos, P. L. (2001). The pricing asymmetry could not have been produced by a structural model employing only standard option. But it is consistent with a hybrid barrier option model. Our model characterizes the valuation of debt under financial stress and the asymmetric price pattern better than both the classical structural and the standard barrier option approaches. It can be extended to the study of individual CDS for its better liquidity than individual corporate bonds. This study provides helpful implications especially for the medium and high‐yield issues in pricing as well as portfolio diversification. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:1161–1189, 2009     

Stock liquidity during COVID-19 crisis: A cross-country analysis of developed and emerging economies,and economic policy uncertainty

We investigate the impact of the COVID-19 on firms' stock liquidity across six developed and emerging economies. Unlike prior literature, we further compare the effects of the pandemic between developed and emerging economies, high and low economic policy uncertainty (EPU), and large and small firms. Our results document the significant negative impact of infection cases and deaths on firms' stock liquidity across the sample countries, and the similar effect of their interaction term. We find that the impact is more pronounced in the developed economies, high EPU and small firms, compared to emerging economies, low EPU and large firms, respectively.     

Bid‐ask spreads,volatility, quote revisions,and trades of thinly traded futures contracts

We investigate intraday bid‐ask spreads (BAS), volatility, and trading activity of thinly traded equity index futures contracts on the Singapore Exchange. Contrary to previous findings, we find a rather flat BAS pattern during the trading day. However, consistent with past findings, an increase in risk widens the spread and a higher trading activity reduces it. When trading occurs in a day, spreads are reduced. No significant difference in volatility between days with and without trades was detected. When trades occur, quote revisions increase, and it is positively related to the number of trades. An increase in the number of quote revisions increases the likelihood of a transaction, and when quotes are current, revisions that are accompanied by trades carry new information. We provide evidence that contracts that are thinly traded may possess liquidity attributes as long as their price quotes remain current. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:455–486, 2003     

The influence of oil price uncertainty on stock liquidity

Using high-frequency intraday data, this study provides strong empirical evidence that elevated oil price uncertainty has a significant and negative influence on stock liquidity. More specifically, the results suggest that large oil-related corporations are most affected, followed by small-listed firms more generally. Further analysis reveals that liquidity providers widen the bid-ask spreads to protect themselves during periods of high oil price uncertainty for large-listed firms, particularly those in the oil industry. These findings are robust to various measures of oil price uncertainty, different market conditions, structural break analysis and show the influence of oil price movements extends to stock liquidity.     

Depths and spreads in futures markets: Relationship with order execution,submission, and cancellation

This paper examines the relationship between limit order submissions and liquidity. We find that there is a negative relationship between the limit order arrival rate and the depth at the best quotes (limit order queue length) and a positive relationship between submissions and bid–ask spreads. This is consistent with queuing theory, which predicts that an increase in the limit order arrival rate increases the queue length and the time to execution of a limit order. Consequently, limit order traders cover the increase in costs and risks associated with the increase in the time to execution of limit orders by increasing bid–ask spread.     

Identifying risks in emerging market sovereign and corporate bond spreads

This paper investigates the systematic risk factors driving emerging market (EM) credit risk by jointly modeling sovereign and corporate credit spreads at a global level. We use a multi-regional Bayesian panel VAR model, with time-varying betas and multivariate stochastic volatility. This model allows us to decompose credit spreads and build indicators of EM risks. A key result is that indices of EM sovereign and corporate credit spreads differ because of their specific reactions to global risks (risk aversion, liquidity and US corporate risk). For example, following Lehman's default, EM sovereign spreads ‘decoupled’ from the US corporate market, whereas EM corporates ‘recoupled.’     

The Co‐Movement of Credit Default Swap Spreads,Equity Returns and Volatility: Evidence from Asia‐Pacific Markets

We provide a comprehensive analysis of the co‐movement of credit default swap (CDS), equity, and volatility markets in four Asia‐Pacific countries at firm and index level during the period 2007–2010. First, we examine lead–lag relationships between CDS spread changes, equity returns, and changes in volatility using a vector autoregressive model. At the firm level equity returns lead changes in CDS spreads and realized volatility. However, at the index level the intertemporal linkages between the three markets are less clear‐cut. Second, we apply the measures proposed by Diebold and Yilmaz (2014) to an analysis of volatility spillovers among the CDS, equities, and volatility asset classes. The results suggest that realized volatility (at firm level) and implied volatility (at index level) are the main transmitters of cross‐market volatility spillovers. Third, we analyze the impact of various structural factors and confirm the importance of realized volatility of equity returns as a determinant of CDS spreads.     

Economic policy uncertainty,bank deposits,and liability structure

This study used data from 2009 to 2017 to investigate the impact of economic policy uncertainty (EPU) on the liability side of Chinese commercial banks. The results show that the increase in EPU leads commercial bank customers to shift from term to demand deposits, which shortens deposit maturity and triggers commercial banks' liquidity-hoarding behavior. Our research provides insights into the motives and strategies behind commercial banks' liquidity hoarding and offers implications for risk management, monetary policy, and systemic financial risk prevention.     

Call Auction Transparency and Market Liquidity: Evidence from China

This paper uses the natural experiment offered by the Shanghai Stock Exchange to investigate the impact of opening call auction transparency on market liquidity. We find that the dissemination of indicative trade information during the pre‐open call auction session leads to an overall improvement in stock liquidity in the continuous trading session. Bid‐ask spreads narrow in the first trading hour because adverse selection risk fell significantly and there is less price volatility in the continuous market. This effect is greater for actively traded securities than illiquid securities. Our findings are robust for different lengths of sample period, different lengths of trading hours after market open, and stocks that had (and had not) reformed the share split structure during our research period.     

More shareholders,higher liquidity? Evidence from an emerging stock market

Using data assembled from all non-financial firms traded on the Malaysian stock exchange, we provide evidence of a nonlinear relationship between the number of shareholders and liquidity. While more shareholders are associated with higher liquidity, the negative effect of wider spreads kicks in when shareholder base exceeds a threshold level due to higher volatility induced by noise trading. However, the threshold level is considerably higher than the number of shareholders of most Malaysian public listed firms, suggesting much room for shareholder expansion in the local market. Our findings call for corporate managers to actively manage and expand their shareholder bases.     

Liquidity shocks,commodity financialization,and market comovements

We explore whether and how liquidity factors influence risk transfers between commodity and stock markets using a composite liquidity index and five different types of liquidity measures. We find that liquidity shocks, including both funding liquidity and market liquidity, are positively associated with comovements between commodity and stock markets after 2000, although the relationship is insignificant before 2000. The structural change indicates that financialization creates a role for adverse liquidity shocks to increase cross-market correlations. Further evidence shows that the effect of liquidity on cross-market correlations is state-dependent and intensifies when liquidity conditions deteriorate and asset returns sustain substantial declines. Our findings are not explained by business cycles.     

Economic policy uncertainty and cash holdings: Evidence from BRIC countries

This paper examines the effect of Economic Policy Uncertainty (EPU) on cash holding decisions of firms in BRIC countries. Our focus is on the firms in BRIC countries, a particularly interesting group of countries to consider given their increasingly important role in the world economy. By using firm-level data through the 10 years period of 2006–2015, we find that firms prefer to hold more cash when uncertainty increases after controlling for firm level variables with industry and year fixed effects. The results are robust to alternative control variables, EPU calculations and selection of sub-samples. In addition to the country specific EPU levels, global EPU also has a significant positive impact on corporate cash holdings.     

Emerging market bond spreads and sovereign credit ratings: reconciling market views with economic fundamentals

This paper uses a panel data estimation of a simple univariate model of sovereign spreads on ratings to analyze statistically significant differences between actual spreads and ratings-based spreads. When such deviations are significant, we find that ‘excessively high’ spreads are on average followed by episodes of spread tightening 1 month later rather than credit downgrades. In contrast, observations with ‘excessively low’ spreads are on average followed by rating upgrades 3 months later rather than episodes of spread widening. The paper also illustrates how significant disagreements between market and rating agencies’ views can be used as a signal that further technical and sovereign analysis is warranted. For instance, we find that spreads were ‘excessively low’ for most emerging markets before the Asian crisis. More recently, spreads were ‘excessively high’ for a number of emerging markets.     

Vulnerable options,risky corporate bond,and credit spread

In the current literature, the focus of credit‐risk analysis has been either on the valuation of risky corporate bond and credit spread or on the valuation of vulnerable options, but never both in the same context. There are two main concerns with existing studies. First, corporate bonds and credit spreads are generally analyzed in a context where corporate debt is the only liability of the firm and a firm’s value follows a continuous stochastic process. This setup implies a zero short‐term spread, which is strongly rejected by empirical observations. The failure of generating non‐zero short‐term credit spreads may be attributed to the simplified assumption on corporate liabilities. Because a corporation generally has more than one type of liability, modeling multiple liabilities may help to incorporate discontinuity in a firm’s value and thereby lead to realistic credit term structures. Second, vulnerable options are generally valued under the assumption that a firm can fully pay off the option if the firm’s value is above the default barrier at the option’s maturity. Such an assumption is not realistic because a corporation can find itself in a solvent position at option’s maturity but with assets insufficient to pay off the option. The main contribution of this study is to address these concerns. The proposed framework extends the existing equity‐bond capital structure to an equity‐bond‐derivative setting and encompasses many existing models as special cases. The firm under study has two types of liabilities: a corporate bond and a short position in a call option. The risky corporate bond, credit spreads, and vulnerable options are analyzed and compared with their counterparts from previous models. Numerical results show that adding a derivative type of liability can lead to positive short‐term credit spreads and various shapes of credit‐spread term structures that were not possible in previous models. In addition, we found that vulnerable options need not always be worth less than their default‐free counterparts. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:301–327, 2001     

Dissecting interbank risk using basis swap spreads

This paper analyses interbank risk using the information content of basis swap (BS) spreads, floating-to-floating interest rate swaps whose payments are associated with euro deposit rates for alternative tenors. To identify the impact of shocks affecting interbank risk, we propose an empirical model that decomposes BS quotes into their expected and unexpected components. These unobservable constituents of BS spreads are estimated by solving a signal extraction problem using a particle filter. We find that expected components covariate with aggregate liquidity and risk aversion while systemic risk arises as the main driver behind unexpected fluctuations. Our empirical findings suggest that macroprudential analysis emerges as a key device to ease asset pricing in a new multi-curve scenario.     

Islamic financing and bank risks: The case of Malaysia

We examine whether Islamic financing can explain three important bank risks in a country with a dual banking system: credit risk, interest‐rate risk, and liquidity risk. Using Malaysian data, we find that commercial banks with Islamic financing have significantly lower credit and liquidity risks but significantly higher interest‐rate risk than banks without Islamic financing. There is also evidence that bank size is significantly related to credit risk; the proportion of loan sales to total liabilities and bank size are significant determinants of interest‐rate risk; and off‐balance‐sheet financing, the extent of securitization, loan volatility, bank capital, and bank size are statistically significantly related to liquidity risk. © 2005 Wiley Periodicals, Inc.