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487
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 businesscycle 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 businesscycle 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.
Term structure dynamics in theory and reality
 Review of Financial Studies
, 2003
"... This paper is a critical survey of models designed for pricing fixed income securities and their associated term structures of market yields. Our primary focus is on the interplay between the theoretical specification of dynamic term structure models and their empirical fit to historical changes in ..."
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Cited by 105 (11 self)
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This paper is a critical survey of models designed for pricing fixed income securities and their associated term structures of market yields. Our primary focus is on the interplay between the theoretical specification of dynamic term structure models and their empirical fit to historical changes in the shapes of yield curves. We begin by overviewing the dynamic term structure models that have been fit to treasury or swap yield curves and in which the risk factors follow diffusions, jumpdiffusion, or have “switching regimes. ” Then the goodnessoffits of these models are assessed relative to their abilities to: (i) match linear projections of changes in yields onto the slope of the yield curve; (ii) match the persistence of conditional volatilities, and the shapes of term structures of unconditional volatilities, of yields; and (iii) to reliably price caps, swaptions, and other fixedincome derivatives. For the case of defaultable securities we explore the relative fits to historical yield spreads. 1
Correlated Default With Incomplete Information
 JOURNAL OF BANKING AND FINANCE
, 2004
"... The recent accounting scandals at Enron, WorldCom, and Tyco were related to the misrepresentation of liabilities. We provide a structural model of correlated multifirm default, in which public bond investors are uncertain about the liabilitydependent barrier at which individual firms default. ..."
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Cited by 93 (11 self)
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The recent accounting scandals at Enron, WorldCom, and Tyco were related to the misrepresentation of liabilities. We provide a structural model of correlated multifirm default, in which public bond investors are uncertain about the liabilitydependent barrier at which individual firms default. In lack of complete information, investors form prior beliefs on the barriers, which they update with the default status information of firms arriving over time. Whenever a firm suddenly defaults, investors learn about the default threshold of closely associated business partner firms. Due to the unpredictable nature of defaults in our model, this updating leads to "contagious" jumps in credit spreads of business partner firms, which correspond to reassessments of these firms' health by investors. We characterize joint default probabilities and the default dependence structure as assessed by imperfectly informed investors, where we emphasize the the modeling of dependence with copulas.
The riskadjusted 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 riskadjusted 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 riskadjusted 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 riskadjusted probabilities of financial distress. Because credit spreads are so large (the "credit spread puzzle"), the magnitude of the distress riskadjustment 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 predistress firm value if we use historical default probabilities, to 4.5% using riskadjusted 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 riskadjusted probabilities, but only 1.1% using historical probabilities. We argue that the magnitude of these marginal, riskadjusted distress costs is similar to the magnitude of the marginal tax benefits of debt derived by
Optimal capital structure and industry dynamics
 Journal of Finance
, 2005
"... This paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt an ..."
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Cited by 73 (18 self)
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This paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and the associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the equilibrium output price has an important feedback effect. This effect has a number of testable implications. For example, high growth industries have relatively lower leverage and turnover rates. THE INTERACTION BETWEEN CAPITAL STRUCTURE and product market decisions has recently received considerable attention in both economics and finance. Beginning
Frailty Correlated Default
 Journal of Finance
, 2009
"... Abstract This paper shows that the probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which b ..."
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Cited by 70 (4 self)
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Abstract This paper shows that the probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and CDO default losses are typically measured for economiccapital and rating purposes, our empirical results indicate that conventionally based estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms existing between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firmbyfirm default probabilities.
Credit Risk and Risk Neutral Default Probabilities: Information About Rating Migrations and Defaults,” working paper
, 1998
"... Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firm’s cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit d ..."
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Cited by 68 (0 self)
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Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firm’s cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit derivatives. While rating agencies such as Moodys and Standard & Poors compute historical default frequencies, option models can also be used to calculate forward looking or expected default frequencies. In this paper, we compute risk neutral probabilities or default (RNPD) using the diffusion models of Merton (1974) and Geske (1977). It is shown that the Geske model produces a term structure of RNPD’s, and the shape of this term structure may forecast impending credit events. Next, it is shown that these RNPD’s serve as bounds to estimates of actual default probabilities. Furthermore, the RNPD’s exhibit the same comparative statics as the estimates of actual default probabilities. Also, the risk neutral default probabilities may be more accurately estimated than actual default probabilities because they do not require an estimate of the firm’s drift. Given these similarities and advantages of RNPD’s, their estimates may possess significant information about credit events. To confirm this an event study of the relation between RNPD
Coordination risk and the price of debt
 MIMEO, LONDON SCHOOL OF ECONOMICS & POLITICAL SCIENCE
, 2001
"... Creditors of a distressed borrower face a coordination problem. Even if the fundamentals are sound, fear of premature foreclosure by others may lead to preemptive action, undermining the project. Recognition of this problem lies behind corporate bankruptcy provisions across the world, and it has be ..."
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Cited by 66 (4 self)
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Creditors of a distressed borrower face a coordination problem. Even if the fundamentals are sound, fear of premature foreclosure by others may lead to preemptive action, undermining the project. Recognition of this problem lies behind corporate bankruptcy provisions across the world, and it has been identified as a culprit in international financial crises, but has received scant attention from the literature on debt pricing. Without common knowledge of fundamentals, the incidence of failure is uniquely determined provided that private information is precise enough. This affords a way to price the coordination failure. Comparative statics on the unique equilibrium provides several insights on the role of information and the incidence of inefficient liquidation.
Connecting Discrete and Continuous PathDependent Options
, 1999
"... . This paper develops methods for relating the prices of discrete and continuoustime versions of pathdependent options sensitive to extremal values of the underlying asset, including lookback, barrier, and hindsight options. The relationships take the form of correction terms that can be interpre ..."
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Cited by 54 (5 self)
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. This paper develops methods for relating the prices of discrete and continuoustime versions of pathdependent options sensitive to extremal values of the underlying asset, including lookback, barrier, and hindsight options. The relationships take the form of correction terms that can be interpreted as shifting a barrier, a strike, or an extremal price. These correction terms enable us to use closedform solutions for continuous option prices to approximate their discrete counterparts. We also develop discretetime discretestate lattice methods for determining accurate prices of discrete and continuous pathdependent options. In several cases, the lattice methods use correction terms based on the connection between discrete and continuoustime prices which dramatically improve convergence to the accurate price. Key words: Barrier options, lookback options, continuity corrections, trinomial trees JEL classification: G13, C63, G12 Mathematics Subject Classification (1991): 90A09, 60J15, 65N06 1
Continuoustime methods in finance: A review and an assessment
 Journal of Finance
, 2000
"... I survey and assess the development of continuoustime methods in finance during the last 30 years. The subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing, term structure theory, asset pricing, and optimal consumption and portfolio choices. ..."
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Cited by 52 (0 self)
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I survey and assess the development of continuoustime methods in finance during the last 30 years. The subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing, term structure theory, asset pricing, and optimal consumption and portfolio choices. During the period 1981 to 1999 the theory has been extended and modified to better explain empirical regularities in various subfields of finance. This latter subperiod has seen significant progress in econometric theory, computational and estimation methods to test and implement continuoustime models. Capital market frictions and bargaining issues are being increasingly incorporated in continuoustime theory. THE ROOTS OF MODERN CONTINUOUSTIME METHODS in finance can be traced back to the seminal contributions of Merton ~1969, 1971, 1973b! in the late 1960s and early 1970s. Merton ~1969! pioneered the use of continuoustime modeling in financial economics by formulating the intertemporal consumption and portfolio choice problem of an investor in a stochastic dynamic programming setting.