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This paper proposes a two-factor hazard-rate model, in closed-form, to price risky debt. The likelihood of default is captured by the firm's non-interest sensitive assets and default-free interest rates. The distinguishing features of the model are threefold. First, impact of capital structure changes on credit spreads can be analyzed. Second, the model allows stochastic interest rates to impact current asset values as well as their evolution. Finally, the proposed model is in closed form enabling us to undertake comparative statics analysis, compute parameter deltas of the model, calibrate empirical credit spreads and determine hedge positions. Credit spreads generated by our model are consistent with empirical observations.

This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. The positive long-run relation between spreads and Treasurys is inconsistent with prominent models for pricing corporate bonds, analyzing capital structure, and measuring the interest rate sensitivity of corporate bonds.

A B S T R A C T A popular approach to modeling and valuing firms views them as webs of contracts between stakeholders. This paper provides an in-depth study of the allocation of residual risks not explicitly managed through such interlocking contracts in the context of project finance. Focusing on the case of the Ras Gas project, we relate its credit spreads as measure of investor risk perceptions to firm-specific risk factors in the context of 25-year supply agreements, debt covenants and a debtservice guarantee contingent on output prices. Consistent with theoretical predictions, we find that unmanaged risk factors affecting the supply agreement drive Ras Gas' credit spreads, but not managed ones. Interpreting our findings as evidence for the nexus of contracts view of the firm, we discuss some implications for financial design and valuation.

this paper are the authors' alone, and in no way reflect those of the World Bank, its Executive Directors, or the countries they represent. The authors would like to thank Peter Christoffersen, Tim Crack, Lutz Kilian, Nagpurnanand Prabhala, John Strong, Alex Triantis and Volker Wieland for stimulating discussions and suggestions, Panos Kogkalidis for excellent research assistance, and participants of the 2000 Asia Development Forum Workshop on Project Finance for comments. Special thanks are due to Greg Randolph, Bim Hundal and Ghassan Abdulkarim, Heads of Structured

database. The authors also thank Alex Vogenthaler and Becky Trubin for outstanding research assistance. The views stated herein are those of the authors and are not necessarily the views of the Federal Reserve Banks of San Francisco or New York, or the Federal Reserve System. Evidence on the costs and benefits of bond IPOs This paper investigates whether it is costly for non–financial firms to enter the public bond market, and whether firms benefit from their bond IPOs. We find that both gross spreads and ex-ante credit spreads are higher for IPO bonds, suggesting that firms pay higher underwriting costs on their first public bond. We also find that underpricing in the secondary market is higher for IPO bonds, further suggesting that it is costly to enter the public bond market. The costs of entering the public bond market are economically meaningful and are higher for risky firms. We investigate the benefits from entering the public bond market, by looking at the costs firms pay to raise external funding subsequently to their bond IPOs. Our results show that these benefits exist, but they accrue only to safe firms. These firms benefit from a reduction both in the interest rates they pay on bank loans and the costs they incur to issue private bonds after they enter the public bond market. Together with our the previous findings, these results lend support to the thesis that bond IPOs are unique. 1

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This study has represented the determinants of sovereign CDS spreads during current sovereign debt crisis in

The credit spread puzzle 1 Spreads on corporate bonds tend to be many times wider than what would be implied by expected default losses alone. These spreads are the difference between yields on corporate debt subject to default risk and government bonds free of such risk. 2 While credit spreads are often generally understood as the compensation for credit risk, it has been difficult to explain the precise relationship between spreads and such risk. In 1997–2003, for example, the average spread on BBB-rated corporate bonds with three to five years to maturity was about 170 basis points at annual rates. Yet, during the same period, the average yearly loss from default amounted to only 20 basis points. In this case, the spread was more than eight times the expected loss from default. The wide gap between spreads and expected default losses is what we call the credit spread puzzle. 3 In this article we argue that the answer to the credit spread puzzle might lie in the difficulty of diversifying default risk. Most studies to date have implicitly assumed that investors can diversify away the unexpected losses in a corporate bond portfolio. However, the nature of default risk is such that the distribution of returns on corporate bonds is highly negatively skewed. Such skewness would require an extraordinarily large portfolio to achieve full diversification. Evidence from the market for collateralised debt obligations (CDOs) indicates that in practice such large portfolios are unattainable, and thus unexpected losses are unavoidable. Hence, we argue that spreads are so wide because they are pricing undiversified credit risk. We first review the existing evidence on the determinants of credit spreads, including the role of taxes, risk premia and liquidity premia. We then

This paper analyzes corporate bond valuation and optimal call and default rules when interest rates and firm value are stochastic. It then uses the results to explain the dynamics of hedging. Bankruptcy rules are important determinants of corporate bond sensitivity to interest rates and firm value. Although endogenous and exogenous bankruptcy models can be calibrated to produce the same prices, they can have very different hedging implications. We show that empirical results on the relation between corporate spreads and Treasury rates provide evidence on duration and find that the endogenous model explains the empirical patterns better than typical exogenous models.