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Variable Rare Disasters: An Exactly Solved Framework for
- Ten Puzzles in Macro Finance, Working Paper, NYU
, 2009
"... This article incorporates a time-varying severity of disasters into the hy- ..."
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Cited by 163 (10 self)
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This article incorporates a time-varying severity of disasters into the hy-
Macroeconomic conditions and the puzzles of credit spreads and capital structure
, 2008
"... Investors demand high risk premia for defaultable claims, because (i) defaults tend to concentrate in bad times when marginal utility is high; (ii) default losses are high during such times. I build a structural model of financing and default decisions in an economy with business-cycle variations in ..."
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Cited by 106 (13 self)
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Investors demand high risk premia for defaultable claims, because (i) defaults tend to concentrate in bad times when marginal utility is high; (ii) default losses are high during such times. I build a structural model of financing and default decisions in an economy with business-cycle variations in expected growth rates and volatility, which endogenously generate countercyclical comovements in risk prices, default probabilities, and default losses. Credit risk premia in the calibrated model not only can quantitatively account for the high corporate bond yield spreads and low leverage ratios in the data, but have rich implications for firms’ financing decisions.
The risk-adjusted cost of financial distress.
- Journal of Finance,
, 2007
"... Abstract In this paper we argue that systematic risk matters for the valuation of financial distress costs. Since financial distress is more likely to happen in bad times, the risk-adjusted probability of financial distress is larger than the historical probability. We propose a methodology for the ..."
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Cited by 75 (3 self)
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Abstract In this paper we argue that systematic risk matters for the valuation of financial distress costs. Since financial distress is more likely to happen in bad times, the risk-adjusted probability of financial distress is larger than the historical probability. We propose a methodology for the valuation of distress costs, which uses observed corporate bond spreads to estimate risk-adjusted probabilities of financial distress. Because credit spreads are so large (the "credit spread puzzle"), the magnitude of the distress risk-adjustment can be substantial, suggesting that a valuation of distress costs that ignores systematic risk significantly underestimates the true value. For a firm whose bonds are rated BBB, our benchmark calculations suggest that the NPV of distress increases from 1.4% of pre-distress firm value if we use historical default probabilities, to 4.5% using risk-adjusted probabilities derived from bond spreads. Marginal distress costs also increase substantially. For example, a leverage increase that changes ratings from AA to BBB is associated with an increase in distress costs of 2.7% using risk-adjusted probabilities, but only 1.1% using historical probabilities. We argue that the magnitude of these marginal, risk-adjusted distress costs is similar to the magnitude of the marginal tax benefits of debt derived by
Stock Options and Credit Default Swaps: A Joint Framework for Valuation and Estimation
- JOURNAL OF FINANCIAL ECONOMETRICS, 2009, 1–41
, 2009
"... We propose a dynamically consistent framework that allows joint valuation and estimation of stock options and credit default swaps written on the same reference company. We model default as controlled by a Cox process with a stochastic arrival rate. When default occurs, the stock price drops to zero ..."
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Cited by 58 (9 self)
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We propose a dynamically consistent framework that allows joint valuation and estimation of stock options and credit default swaps written on the same reference company. We model default as controlled by a Cox process with a stochastic arrival rate. When default occurs, the stock price drops to zero. Prior to default, the stock price follows a jump-diffusion process with stochastic volatility. The instantaneous default rate and variance rate follow a bivariate continuous process, with its joint dynamics specified to capture the observed behavior of stock option prices and credit default swap spreads. Under this joint specification, we propose a tractable valuation methodology for stock options and credit default swaps. We estimate the joint risk dynamics using data from both markets for eight companies that span five sectors and six major credit rating classes from B to AAA. The estimation highlights the interaction between market risk (return variance) and credit risk (default arrival) in pricing stock options and credit default swaps.
How the Subprime Crisis Went Global: Evidence from Bank Credit Default Swap Spreads,” NBER Working Paper No. 14904
, 2009
"... How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks ’ credit default swap spreads. We find that fortunes of ..."
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Cited by 54 (4 self)
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How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks ’ credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman’s failure, the prospect of global recession became imminent, auguring the further deterioration of banks ’ loan portfolios. At this point the entire global financial system had become infected. 1
Recovery rates, default probabilities and the credit cycle
- Journal of Banking and Finance
"... In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserve ..."
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Cited by 24 (0 self)
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In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the “credit cycle”. This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models.
2006): “Realized Jumps on Financial Markets and Predicting Credit Spreads,” Unpublished working paper
"... This paper extends the jump detection method based on bi-power variation to identify realized jumps on financial markets and to estimate parametrically the jump intensity, mean, and variance. Finite sample evidence suggests that jump parameters can be accurately estimated and that the statistical in ..."
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Cited by 18 (2 self)
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This paper extends the jump detection method based on bi-power variation to identify realized jumps on financial markets and to estimate parametrically the jump intensity, mean, and variance. Finite sample evidence suggests that jump parameters can be accurately estimated and that the statistical inferences can be reliable, assuming that jumps are rare and large. Applications to equity market, treasury bond, and exchange rate reveal important differences in jump frequencies and volatilities across asset classes over time. For investment grade bond spread indices, the estimated jump volatility has a better forecasting power than the interest rate factors, volatility factors including option-implied volatility, with control for systematic risk factors. A market jump risk factor seems to capture the low frequency movements in credit spreads.
Identifying realized jumps on financial markets
, 2006
"... This paper extends the jump detection method based on bi-power variation and swap variance measures to identify realized jumps on financial markets and to esti-mate parametrically the jump intensity, mean, and variance. Such an approach does not require specifying and estimating the underlying drift ..."
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Cited by 17 (0 self)
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This paper extends the jump detection method based on bi-power variation and swap variance measures to identify realized jumps on financial markets and to esti-mate parametrically the jump intensity, mean, and variance. Such an approach does not require specifying and estimating the underlying drift and diffusion functions. Fi-nite sample evidence suggests that the jump parameters can be accurately estimated and that the statistical inferences can be reliable relative to the maximum likelihood estimation, under the appropriate choice of jump detection test level and assuming that jumps are rare and large. The bi-power variation approach performs slightly better than the swap variance approach when the jump contribution to total variance is small. Applications to equity market, treasury bond, individual stock, and exchange rate re-veal important differences in jump frequencies and volatilities across asset classes over time. For high investment grade credit spread indices, the estimated jump volatility has a better forecasting power than interest rate factors, volatility factors including option-implied volatility, and Fama-French risk factors.
Can standard preferences explain the prices of out-of-themoney S&P 500 put options? Working Paper
, 2005
"... Prior to the stock market crash of 1987, Black-Scholes implied volatilities of S&P 500 index options were relatively constant across moneyness. Since the crash, however, deep out-of-the-money S&P 500 put options have become ‘expensive ’ relative to the Black-Scholes benchmark. Many researche ..."
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Cited by 13 (0 self)
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Prior to the stock market crash of 1987, Black-Scholes implied volatilities of S&P 500 index options were relatively constant across moneyness. Since the crash, however, deep out-of-the-money S&P 500 put options have become ‘expensive ’ relative to the Black-Scholes benchmark. Many researchers (e.g., Liu, Pan and Wang (2005)) have argued that such prices cannot be justified in a general equilibrium setting if the representative agent has ‘standard preferences’ and the endowment is an i.i.d. process. Below, however, we use the insight of Bansal and Yaron (2004) to demonstrate that the ‘volatility smirk ’ can be rationalized if the agent is endowed with Epstein-Zin preferences and if the aggregate dividend and consumption processes are driven by a persistent stochastic growth variable that can jump. We identify a realistic calibration of the model that simultaneously matches the empirical properties of dividends, the equity premium, the prices of both at-the-money and deep out-of-the-money puts, and the level of the risk-free rate. A more challenging question (that to our knowledge has not been previously investigated) is whether one can explain within a standard preference framework the stark regime change in
