DSpace Collection: Credit & Debt Markets

Why Does Capital Structure Choice Vary With Macroeconomic Conditions?

Thu, 30 Nov 2000 22:58:59 GMT

Title: Why Does Capital Structure Choice Vary With Macroeconomic Conditions?

Levy, Amnon

Abstract: This paper develops a calibrated model that explains the pronouncedcounter-cyclical leverage patterns observed for firms that access publiccapital markets, and relates these patterns to debt and equity issues.Moreover, it explains why leverage and debt issues do not exhibit thispronounced behavior for firms that face more severe constraints whenaccessing capital markets. In the model, managers issue a combination ofdebt and equity to finance investment by weighting the trade-off betweenagency problems and risk sharing. During contraction, leveraged managersreceive a relatively small share of wealth, resulting in a relativeincrease in household demand for securities. Securities markets clear asmanagers that are not up against their borrowing constraints increaseleverage while satisfying the agency condition that they maintain alarge enough portion of their firm's equity.

When Does Strategic Debt Service Matter?

Wed, 01 May 2002 22:58:59 GMT

Title: When Does Strategic Debt Service Matter?

Acharya, Viral V.; Huang, Jing-zhi; Subrahmanyam, Marti G.; Sundaram, Rangarajan K.

Abstract: Recent work has suggested that strategic underperformance ofdebt-service obligations by equity holders can resolve the gap betweenobserved yield spreads and those generated by Merton (1974)-stylemodels. We show that this is not quite correct. The value of the optionto underperform on debt-service obligations depends on two otheroptionalities available to equity holders, namely, the option to carrycash reserves within the firm and the option to raise new externalfinancing. We disentangle the effects of the three factors, andcharacterize the impact of each in isolation as well as theirinteraction. We find, among other things, that while strategic behaviorcan increase spreads significantly under some conditions, its impact isnegligible in others, and in some cases it even leads to a decline inequilibrium spreads. We show that this last apparently paradoxicalresult is a consequence of an interaction of optionalities that resultsin a trade-off between strategic and liquidity-driven defaults.

WHAT HAPPENED TO LIQUIDITY WHEN WORLD WAR I SHUT THE NYSE?

Tue, 29 Jul 2003 22:58:59 GMT

Title: WHAT HAPPENED TO LIQUIDITY WHEN WORLD WAR I SHUT THE NYSE?

Silber, William L.

Abstract: The suspension of trading on the New York Stock Exchange for more thanfour months following the outbreak of World War I fostered a substitutemarket on New Street as a source of liquidity. The New Street marketsuffered from a lack of price transparency because its transactions werenot disseminated on the NYSE ticker and its quotations were blacklistedat the leading newspapers. This paper shows that despite the impairedinformation flow and the somewhat wider bid-ask spreads compared withthe New York Stock Exchange, New Street offered economically meaningfulliquidity services. The absence of price transparency turned anindividual stock’s reputation for liquidity into an importantvariable in explaining the structure of bid-ask spreads on New Street

The Long-Run Behavior of Debt and Equity Underwriting Spreads

Tue, 31 Dec 2002 22:58:59 GMT

Title: The Long-Run Behavior of Debt and Equity Underwriting Spreads

Kim, Dongcheol; Palia, Darius; Saunders, Anthony

Abstract: This paper is the first to look at the long-run (30-year) behavior ofunderwriting spreads in the markets for corporate equity and debt.Specifically, we analyze the determinants of underwriting spreads oncorporate bond issues, secondary equity offerings and initial publicofferings over the period 1970-2000. We explain the time-varyingcross-sectional behavior of these spreads by analyzing three sets ofvariables or factors: macro (systematic) factors, investment bankingmarket structure factors and issuer specific characteristics. We alsoanalyze the relationship between the direct costs (underwriting spreads)and indirect costs (underpricing) of new issues. Among our many resultswe find an apparent decline in spreads over time, an increasedclustering in spreads for both IPOs and SEOs, the dominance of issuer-specific characteristics in explaining spreads, and a relatively weaklinkage between the direct and indirect costs of issuance.

The Link between Default and Recovery Rates: Theory, Empirical Evidence and Implications

Wed, 26 Feb 2003 22:58:59 GMT

Title: The Link between Default and Recovery Rates: Theory, Empirical Evidenceand Implications

Altman, Edward I.; Brady, Brooks; Resti, Andrea; Sironi, Andrea

Abstract: This paper analyzes the association between aggregate default andrecovery rates on credit assets, and seeks to empirically explain thiscritical relationship. We examine recovery rates on corporate bonddefaults, over the period 1982-2002. Our econometric univariate andmultivariate models explain a significant portion of the variance inbond recovery rates aggregated across all seniority and collaterallevels. The central thesis is that aggregate recovery rates arebasically a function of supply and demand for the securities, withdefault rates playing a pivotal role. Such a link would bring about asignificant increase in both expected and unexpected losses as measuredby some widespread credit risk models, and would affect theprocyclicality effects of the New Basel Capital Accord. Our results havealso important implications for investors in corporate bonds and bankloans, and for all markets (e.g., securitizations, credit derivatives)that depend on recovery rates as a key variable.

The Link between Default and Recovery Rates: Implications for Credit Risk Models and Procyclicality

Fri, 28 Jun 2002 22:58:59 GMT

Title: The Link between Default and Recovery Rates: Implications for CreditRisk Models and Procyclicality

Altman, Edward I.; Brady, Brooks; Resti, Andrea; Sironi, Andrea

Abstract: This paper analyzes the impact of various assumptions about theassociation between aggregate default probabilities and the loss givendefault on bank loans and corporate bonds, and seeks to empiricallyexplain this critical relationship. Moreover, it simulates the effectson mandatory capital requirements like those proposed in 2001 by theBasel Committee on Banking Supervision. We present the analysis andresults in four distinct sections. The first section examines theliterature of the last three decades of the various structural-form,closed-form and other credit risk and portfolio credit value-at-risk(VaR) models and the way they explicitly or implicitly treat therecovery rate variable. Section 2 presents simulation results underthree different recovery rate scenarios and examines the impact of thesescenarios on the resulting risk measures: our results show a significantincrease in both expected and unexpected losses when recovery rates arestochastic and negatively correlated with default probabilities. InSection 3, we empirically examine the recovery rates on corporate bonddefaults, over the period 1982-2000. We attempt to explain recoveryrates by specifying a rather straightforward statistical least squaresregression model. The central thesis is that aggregate recovery ratesare basically a function of supply and demand for the securities. Oureconometric univariate and multivariate time series models explain asignificant portion of the variance in bond recovery rates aggregatedacross all seniority and collateral levels. Finally, in Section 4 weanalyze how the link between default probability and recovery risk wouldaffect the procyclicality effects of the New Basel Capital Accord, dueto be released in 2002. We see that, if banks use their own estimates ofLGD (as in the "advanced" IRB approach), an increase in thesensitivity of banks’ LGD due to the variation in PD over economiccycles is likely to follow. Our results have important implications forjust about all portfolio credit risk models, for markets which depend onrecovery rates as a key variable (e.g., securitizations, creditderivatives, etc.), for the current debate on the revised BIS guidelinesfor capital requirements on bank credit assets, and for investors incorporate bonds of all credit qualities.

The Link between Default and Recovery Rates

Fri, 29 Aug 2003 22:58:59 GMT

Title: The Link between Default and Recovery Rates

Altman, Edward I.; Brady, Brooks; Resti, Andrea; Sironi, Andrea

Abstract: This paper analyzes the association between aggregate default andrecovery rates on credit assets, and seeks to empirically explain thiscritical relationship. We examine recovery rates on corporate bonddefaults, over the period 1982-2002. Our econometric univariate andmultivariate models explain a significant portion of the variance inbond recovery rates aggregated across all seniority and collaterallevels. The central thesis is that aggregate recovery rates arebasically a function of supply and demand for the securities, withdefault rates playing a pivotal role. Such a link would bring about asignificant increase in both expected and unexpected losses as measuredby some widespread credit risk models, and would affect theprocyclicality effects of the New Basel Capital Accord. Our results havealso important implications for investors in corporate bonds and bankloans, and for all markets (e.g., securitizations, credit derivatives)that depend on recovery rates as a key variable.

THE INVESTMENT PERFORMANCE AND MARKET SIZE OF DEFAULTED BONDS AND BANK LOANS IN 2003: OUTLOOK FOR 2004/2005

Thu, 29 Jan 2004 22:58:59 GMT

Title: THE INVESTMENT PERFORMANCE AND MARKET SIZE OF DEFAULTED BONDS AND BANKLOANS IN 2003: OUTLOOK FOR 2004/2005

Altman, Edward I.; Kumar, Rohit

The Impact of Shareholder Control on Bondholders

Fri, 27 Feb 2004 22:58:59 GMT

Title: The Impact of Shareholder Control on Bondholders

Cremers, K.J. Martijn; Nair, Vinay B.; Wei, Chenyang (Jason)

Abstract: This paper investigates the effect of shareholder control on bondholderwealth. While stronger shareholder control can benefit bondholders bydisciplining managers, it also increases the likelihood of events thatcan hurt bondholders, e.g. hostile takeovers. We hypothesize thatshareholder control can have contrasting effects on bond yieldsdepending on the takeover vulnerability of a firm. Using the presence ofan institutional blockholder to proxy for shareholder control andfirm-level anti-takeover provisions to proxy for takeover vulnerability,we find that shareholder control is associated with lower yields if thefirm is protected from takeovers. We also find that shareholder controlis associated with higher yields if the firm is exposed to takeovers.The contrasting effects of shareholder control on yields are thestrongest for firms that are small and have low leverage. In thepresence of shareholder control, the difference in bond yields due todifferences in takeover vulnerability can be as high as 93 basis points.Further, the results are insignificant for a sub-sample of firms wherethe bondholders are protected from takeovers through the poison putcovenant. Bond ratings also appear to incorporate a similar effect ofshareholder control on bondholders Finally, we find that a bond pricingmodel that does not account for shareholder control generates anannualized abnormal return of 1% to 1.4% for portfolios that long firmswith both strong shareholder control and high takeover vulnerability andshort firms without either shareholder control or takeovervulnerability. Combined, these results suggest that the use of differentgovernance mechanisms, such as shareholder monitoring and takeovervulnerability, depends on a firm’s capital structure and thatbond-pricing models should account for shareholder control.

TENDER OFFERS AND LEVERAGE

Sat, 28 Jun 2003 22:58:59 GMT

Title: TENDER OFFERS AND LEVERAGE

Mueller, Holger M.; Panunzi, Fausto

Abstract: We examine the role of leverage in tender offers for widely held firms.Leverage allows raiders to appropriate part of the value gains arisingfrom takeovers, hence reducing the takeover premium and mitigating thefree-rider problem. Leveraged takeovers may thus be profitable even iftarget shareholders are dispersed. Bankruptcy costs, incentive problemson the part of the raider, and defensive leveraged recapitalizations andasset sales by the target management all limit the raider’sability to borrow, thus shifting takeover gains to target shareholdersand reducing the takeover likelihood. While bankruptcy costs are asocial cost, the takeover premium is merely a wealth transfer to targetshareholders. As the raider does not maximize social welfare, he usestoo much debt compared to the social optimum.

Risk Management, Capital Structure and Capital Budgeting in Financial Institutions

Tue, 26 Sep 2000 22:58:59 GMT

Title: Risk Management, Capital Structure and Capital Budgeting in Financial Institutions

Cebenoyan, A. Sinan; Strahan, Philip E.

Abstract: We test how active management of bank credit risk exposure affectscapital structure, capital budgeting and profits. We find that banksthat rebalance their C&I loan portfolio exposures by both buying andselling loans hold less capital and lower levels of liquid assets thanother banks; they also lend more to businesses, both as a percentage oftotal assets and as a percentage of their overall lending, and theyenjoy higher profits. The results hold controlling for bank size andholding company affiliation and are robust over time. We conclude thatincreasingly sophisticated risk management practices in banking arelikely to improve the availability of bank credit.

Risk Management with Benchmarking

Fri, 28 Sep 2001 22:58:59 GMT

Title: Risk Management with Benchmarking

Basak, Suleyman; Shapiro, Alex; Tepla, Lucie

Abstract: Portfolio theory must address the fact that in reality, portfoliomanagers are evaluated relative to a benchmark, and therefore adopt riskmanagement practices to account for the benchmark performance. Wecapture this risk management consideration by allowing a prespecifiedshortfall from a target benchmark-linked return, consistent with growinginterest in such practice. In a dynamic setting, we demonstrate how arisk averse portfolio manager optimally under- or overperforms a targetbenchmark under different economic conditions, depending on his attitudetowards risk and choice of the benchmark. Investors can thereforeachieve their desired gain/loss characteristics for funds undermanagement through an appropriate combined choice of the benchmark andmoney manager.

Risk Aversion and Allocation to Long-Term Bonds

Mon, 29 Oct 2001 22:58:59 GMT

Title: Risk Aversion and Allocation to Long-Term Bonds

Wachter, Jessica A.

Abstract: As risk aversion approaches infinity, the portfolio of an investor withutility over consumption at time T is shown to converge to the portfolioconsisting entirely of a bond maturing at time T. Previous work on bondallocation requires a specific model for equities, the term structure,and the investor's utility function. In contrast, the only substantiveassumption required for the analysis in this paper is that markets arecomplete. The result, which holds regardless of the underlyinginvestment opportunities and the utility function, formalizes the"preferred habitat" intuition of Modigliani and Sutch.

Revisiting Credit Scoring Models in a Basel 2 Environment

Sun, 28 Apr 2002 22:58:59 GMT

Title: Revisiting Credit Scoring Models in a Basel 2 Environment

Altman, Edward I.

Abstract: This paper discusses two of the primary motivating influences on therecent development/revisions of credit scoring models, i.e., theimportant implications of Basel 2’s proposed capital requirementson credit assets and the enormous amounts and rates of defaults andbankruptcies in the US in 2001-2002. Two of the more prominent creditscoring techniques, Z-Score and KMV’s EDF models, are reviewed.Finally, both models are assessed with respect to default probabilitiesin general and in particular to the infamous Enron debacle. In order tobe effective, these and other credit risk models should be utilized byfirms with a sincere credit risk culture.

Regime Shifts in a Dynamic Term Structure Model of U.S. Treasury Bond Yields

Mon, 20 Oct 2003 22:58:59 GMT

Title: Regime Shifts in a Dynamic Term Structure Model of U.S. Treasury Bond Yields

Dai, Qiang; Singleton, Kenneth J.; Yang, Wei

Abstract: This paper develops and empirically implements an arbitrage-free,dynamic term structure model with "priced" factor andregime-shift risks. The risk factors are assumed to follow adiscrete-time Gaussian process, and regime shifts are governed by adiscrete-time Markov process with state-dependent transitionprobabilities. This model gives closed-form solutions for zero-couponbond prices and an analytic representation of the likelihood functionfor bond yields. Using monthly data on U.S. Treasury zero-coupon bondyields, we document notable differences in the behaviors of the marketprices of factor risk across high and low volatility regimes.Additionally, the state-dependence of the regime-switching probabilitiesis shown to capture an interesting asymmetry in the cyclical behavior ofinterest rates. The shapes of the term structures of bond yieldvolatilities are also very different across regimes, with the well-knownhump in volatility being largely a low-volatility regime phenomenon.

Rating Agencies: Is There an Agency Issue?

Fri, 28 Sep 2001 22:58:59 GMT

Title: Rating Agencies: Is There an Agency Issue?

Smith, Roy C.; Walter, Ingo

Abstract: This paper examines the potential for conflicts of interest in the debtratings business. Inherent in the current business model is the factthat firms whose obligations are rated by the agencies pay fees forthose ratings, which in turn comprises virtually all of the revenues ofthe rating agencies. Given the public nature of the ratings, no otherbusiness model seems feasible for rating agencies as commercialventures, so that conflicts of interest are inherent in this importantpart of the financial markets infrastructure. This paper examines thenature of this conflict, how it is managed, and the significance ofmarket structure and reputation in preventing conflict exploitation.These issues are linked to the use of ratings for regulatorycertification purposes, as well as the international dimensions of debtratings activity through investments and joint ventures of the majorrating groups.

Pricing Inflation-Indexed Convertible Bonds with Credit Risk

Tue, 29 Oct 2002 22:58:59 GMT

Title: Pricing Inflation-Indexed Convertible Bonds with Credit Risk

Landskroner, Yoram; Raviv, Alon

Abstract: In Issuing convertible bonds has become a popular way of raising capitalby corporations in the last few years. An important subgroup isconvertibles linked to a price index or exchange rate. The valuationmodel of inflation-indexed (or equivalently foreign-currency)convertible bonds derived in this paper considers two sources ofuncertainty allowing both the underlying stock and theconsumer-price-index to be stochastic and incorporates credit risk inthe analysis. We approximate the pricing equations by using a Rubinstein(1994) three-dimensional binomial tree, and we describe the numericalsolution. We investigate the sensitivity of the theoretical values withrespect to the characteristics of the issuer, the economic environmentand the security’s characteristics (number of principal payments).Moreover, we demonstrate the usefulness and the limitations of thepricing model by using inflation-indexed and foreign-currency linkedconvertibles traded on the Tel- Aviv stock exchange.

Pricing Credit Derivatives with Rating Transitions

Sun, 04 Nov 2001 22:58:59 GMT

Title: Pricing Credit Derivatives with Rating Transitions

Acharya, Viral V.; Das, Sanjiv Ranjan; Sundaram, Rangarajan K.

Abstract: We develop a model for pricing risky debt and valuing credit derivativesthat is easily calibrated to existing variables. Our approach is basedon expanding the Das and Sundaram (2000) extension of theHeath-Jarrow-Morton (1990) term-structure model to allow for multipleratings classes of debt. The framework has two salient features: (i) itemploys a ratings transition matrix as the driver or the defaultprocess, and (ii) the entire set of rating categories is calibratedjointly, allowing arbitrage-free restrictions across rating classes, asa bond migrates amongst them. We provide an illustration of the approachby applying it to price credit-sensitive notes that have coupon paymentsthat are linked to the rating of the underlying credit.

Modeling Sovereign Yield Spreads: A Case Study of Russian Debt

Sun, 23 Sep 2001 22:58:59 GMT

Title: Modeling Sovereign Yield Spreads: A Case Study of Russian Debt

Duffie, Darrell; Pedersen, Lasse Heje; Singleton, Kenneth J.

Abstract: We construct a model for pricing sovereign debt that accounts for therisks of both default and restructuring, and allows for compensation forilliquidity. Using a new and relatively efficient method, we estimatethe model using Russian dollar-denominated bonds. We consider thedeterminants of the Russian yield spread, the yield differential acrossdifferent Russian bonds, and the implications for market integration,relative liquidity, relative expected recovery rates, and impliedexpectations of different default scenarios.

Market Size and Investment Performance of Defaulted Bonds and Bank Loans: 1987-2002

Wed, 29 Jan 2003 22:58:59 GMT

Title: Market Size and Investment Performance of Defaulted Bonds and BankLoans: 1987-2002

Altman, Edward I.; Jha, Shubin

Abstract: The defaulted and distressed, public and private debt markets in theUnited States increased enormously to a record $942 billion (face value)at the end of 2002. The market value of this increasingly attractivealternative investment segment was approximately $512 billion.Defaulted securities performed below average in 2002; absolute returns,as measured by our various defaulted debt indexes, were - 6.0% on bonds,+3.0% on bank loans, and - 0.5% on the combined defaulted public bondsand private bank loans index. The Altman-NYU Salomon Center Index ofDefaulted Bonds grew to a face value of $61.5 billion. Themarket-to-face value ratio of the Bond Index fell to 0.17 from 0.21 oneyear ago. The face value of our Defaulted Bank Loan Index was $37.7billion and the market-to-face value ratio dropped to a record low levelof 0.46 by the end of 2002. The recovery rate on defaulted bonds(price just after default) was very low at 25 cents on the dollar;likewise, the weighted average bank loan recovery rate in 2002 droppedto 52 cents on the dollar. With new defaulted bonds rising in 2002 to arecord $96.9 billion (default rate of 12.8%) and the default outlook for2003 high, but lower than for 2002, investment opportunities shouldabound in the distressed debt market. Indications are that distressedinvestors (both old and new entities) are successfully raising fundsbecause investor expectations are buoyant.

Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt

Fri, 29 Dec 2000 22:58:59 GMT

Title: Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt

Brito, José Almeida; John, Kose

Abstract: This paper shows that illiquid growth opportunities crucially impact theagency costs of risky debt. If the value of these growth opportunitiesis sufficiently high, they reverse riskshifting incentives intorisk-avoidance incentives, creating a new agency cost of debt. They canalso eliminate Myers’s underinvestment problem. It is widelyaccepted in Corporate Finance that risky debt induces incentives forrisk-shifting by the residual equityholder. This paper shows that thisresult is subject to important qualifications: risky debt does notnecessarily create risk-shifting incentives. For a relevant subset offirms it creates instead the opposite effect: it induces risk-avoidancebehavior. With risky debt outstanding, the shareholders of a firm withilliquid growth opportunities may optimally prefer safer, less valuableprojects to riskier projects with higher net present values. Theseshareholders present risk-avoidance behavior to preserve control of thefirm and to appropriate the firm’s future economic rents. Thepaper models the firm’s risk choices in a framework that shows theex-post optimality of both risk-avoidance and risk-shifting behavior.The presence of illiquid growth opportunities extends the maturity ofthe equity contract beyond the maturity of the debt contract, explicitlyaccounting for the nature of the firm as a going concern. The paperconstitutes a contribution towards a multiperiod perspective inCorporate Finance, while retaining the parsimony and elegance offinite-period settings.

Issues in the Credit Risk Modeling of Retail Markets

Wed, 29 Jan 2003 22:58:59 GMT

Title: Issues in the Credit Risk Modeling of Retail Markets

Allen, Linda; DeLong, Gayle; Saunders, Anthony

Abstract: Retail loan markets create special challenges for credit riskassessment. Borrowers tend to be informationally opaque and borrowrelatively infrequently. Retail loans are illiquid and do not trade insecondary markets. For these reasons, historical credit databases areusually not available for retail loans. Moreover, even when data areavailable, retail loan values are small in absolute terms and thereforeapplication of sophisticated modeling is usually not cost effective onan individual loan-by-loan basis. These features of retail lending haveled to the development of techniques that rely on portfolio aggregationin order to measure retail credit risk exposure. BIS proposals for theBasel New Capital Accord differentiate portfolios of mortgage loans fromrevolving credit loan portfolios from other retail loan portfolios inassessing the bank’s minimum capital requirement. We survey themost recent BIS proposals for the credit risk measurement of retailcredits in capital regulations. We also describe the recent trend awayfrom relationship lending toward transactional lending, even in thesmall business loan arena traditionally characterized by small banksextending relationship loans to small businesses. These trends createthe opportunity to adopt more analytical, data-based approaches tocredit risk measurement. We survey proprietary credit scoring models(such as Fair, Isaac and SMEloan), as well as options-theoreticstructural models (such as KMV and Moody’s RiskCalc) and reducedform models (such as Credit Risk Plus).

Is the "Leverage Effect" a Leverage Effect?

Sun, 05 Nov 2000 22:58:59 GMT

Title: Is the "Leverage Effect" a Leverage Effect?

Figlewski, Stephen; Wang, Xiaozu

Abstract: The "leverage effect" refers to the well-establishedrelationship between stock returns and both implied and realizedvolatility: volatility increases when the stock price falls. A standardexplanation ties the phenomenon to the effect a change in marketvaluation of a firm's equity has on the degree of leverage in itscapital structure, with an increase in leverage producing an increase instock volatility. We use both returns and directly measured leverage toexamine this hypothetical explanation for the "leverageeffect" as it applies to the individual stocks in the S&P100(OEX) index, and to the index itself. We find a strong "leverageeffect" associated with falling stock prices, but also numerousanomalies that call into question leverage changes as the explanation.These include the facts that the effect is much weaker or nonexistentwhen positive stock returns reduce leverage; it is too small withmeasured leverage for individual firms, but much too large for OEXimplied volatilities; the volatility change associated with a givenchange in leverage seems to die out over a few months; and there is noapparent effect on volatility when leverage changes because of a changein outstanding debt or shares, only when stock prices change. In short,our evidence suggests that the "leverage effect" is really a"down market effect" that may have little direct connection tofirm leverage.

Informational Efficiency of Loans versus Bonds: Evidence from Secondary Market Prices

Sun, 28 Sep 2003 22:58:59 GMT

Title: Informational Efficiency of Loans versus Bonds: Evidence from SecondaryMarket Prices

Altman, Edward; Gande, Amar; Saunders, Anthony

Abstract: This paper examines the informational efficiency of loans relative tobonds surrounding loan default dates and bond default dates. We examinethis issue using a unique dataset of daily secondary market prices ofloans over the 11/1999-06/2002 period. We find evidence consistent witha monitoring role of loans. Specifically, consistent with a view thatthe monitoring role of loans should be reflected in more preciseexpectations embedded in loan prices, we find that the price decline ofloans is less adverse than that of bonds of the same borrower aroundloan and bond default dates. Additionally, we find evidence that thedifference in price decline of loans versus bonds is amplified aroundloan default dates that are not preceded by a bond default date of thesame company. Our results are robust to several alternativeexplanations, and to controlling for security-specific characteristics,such as seniority, collateral, covenants, and for multiple measures ofcumulative abnormal returns. Overall, we find that the loan market isinformationally more efficient than the bond market around loan defaultdates and bond default dates.

Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature

Thu, 28 Nov 2002 22:58:59 GMT

Title: Incorporating Systemic Influences Into Risk Measurements: A Survey ofthe Literature

Allen, Linda; Saunders, Anthony

Abstract: Procyclicality has emerged as a potential drawback to adoption ofrisk-sensitive bank capital requirements. Systematic risk factors mayresult in increases (decreases) in bank capital requirements when theeconomy is depressed (overheated), thereby decreasing (increasing) banklending capacity and exacerbating business cycle fluctuations.Procyclicality may result from systematic risk emanating from commonmacroeconomic influences or from interdependencies across firms asfinancial markets and institutions consolidate internationally. Wedescribe cyclical effects on operational risk, credit risk and marketrisk measures.

Income Smoothing over the Business Cycle: Changes in Banks’ Coordinated Management of Provisions for Loan Losses and Loan Charge-offs from the Pre-1990 Bust to the 1990s Boom

Mon, 28 Apr 2003 22:58:59 GMT

Title: Income Smoothing over the Business Cycle: Changes in Banks’Coordinated Management of Provisions for Loan Losses and LoanCharge-offs from the Pre-1990 Bust to the 1990s Boom

Liu, Chi-Chun; Ryan, Stephen G.

Abstract: We provide evidence that banks smooth income by managing provisions forloan losses and loan charge-offs in a coordinated fashion that variesacross the bust and boom phases of the business cycle and acrosshomogeneous and heterogeneous loan types. In particular, during the1990s boom, we predict and find that banks accelerated provisioning forloan losses and made this less obvious by accelerating loan charge-offs,especially for homogenous loans for which charge-offs are determinedusing number-of-days-past-due rules. We also provide evidence that thevaluation implications of banks’ provisions for loan losses andloan charge-offs vary across the phases of the business cycle and loantypes reflecting the effect of these factors on banks’ incomesmoothing. In particular, during the 1990s boom, we predict and findthat charge-offs of homogenous loans have a positive association withcurrent returns and future cash flows, because these charge-offs arerecorded primarily by healthy banks with good future prospects reducingover-stated allowances for loan losses. We also predict and find thatthese charge-offs have a positive association with future returns thatis explained by their positive association with future net income andrecoveries. Our results are consistent with the market only partiallyappreciating healthy banks’ overstatement of charge-offs ofhomogeneous loans based on number-of-days-past-due rules during the1990s boom, because of the perceived non-discretionary nature of these charge-offs.

HOW RATING AGENCIES ACHIEVE RATING STABILITY

Fri, 28 Nov 2003 22:58:59 GMT

Title: HOW RATING AGENCIES ACHIEVE RATING STABILITY

Altman, Edward I.; Rijken, Herbert A.

Abstract: Surveys on the use of agency credit ratings reveal that most investorsbelieve that rating agencies are relatively slow in adjusting theirratings. A well-accepted explanation for this perception on thetimeliness of agency ratings is the "through-the-cycle"methodology, which agencies apply in their rating assessments, whileinvestors have a "point-in-time" perception on thecreditworthiness. The “through-the-cycle” methodology aimsto suppress the sensitivity of the ratings to short-term fluctuations incredit quality. This article focuses on the migration policy of ratingagencies as a second source of rating stability. In a benchmark studywith credit scoring models we show that both the"through-the-cycle" methodology and the conservative migrationpolicy are responsible for the investors' perception of the rigidity ofagency ratings.

How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk?

Sat, 28 Sep 2002 22:58:59 GMT

Title: How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk?

Huang, Jing-zhi; Huang, Ming

Abstract: No consensus has yet emerged from the existing credit risk literature onhow much of the observed corporate-Treasury yield spreads can beexplained by credit risk. In this paper, we propose a new calibrationapproach based on historical default data and show that one can indeedobtain consistent estimate of the credit spread across many differenteconomic considerations within the structural framework of credit riskvaluation. We find that credit risk accounts for only a small fractionof the observed corporate-Treasury yield spreads for investment gradebonds of all maturities, with the fraction smaller for bonds of shortermaturities; and that it accounts for a much higher fraction of yieldspreads for junk bonds. We obtain these results by calibrating each ofthe models - both existing and new ones - to be consistent with data onhistorical default loss experience. Different structural models, whichin theory can still generate a very large range of credit spreads, areshown to predict fairly similar credit spreads under empiricallyreasonable parameter choices, resulting in the robustness of our conclusion.

Habit Formation and Returns on Bonds and Stocks

Tue, 14 May 2002 22:58:59 GMT

Title: Habit Formation and Returns on Bonds and Stocks

Wachter, Jessica A.

Abstract: This paper proposes a habit formation model that explains the failure ofthe expectations hypothesis documented by Campbell and Shiller (1991)and Fama and Bliss (1987). The model also produces positive excessreturns on long-term bonds, an upward sloping average yield curve, andallows for realistic levels of time-variation in the mean of consumptiongrowth. The model generates a novel empirical prediction: Long lags ofconsumption growth predict the short-term interest rate with a negativesign. This prediction is shown to be strongly supported by the data.

Fixed Income Pricing

Sun, 30 Jun 2002 22:58:59 GMT

Title: Fixed Income Pricing

Dai, Qiang; Singleton, Kenneth

Abstract: This chapter surveys the literature on fixed-income pricing models,including dynamic term structure models (DTSMs) and interest ratesensitive, derivative pricing models. This literature is vast with boththe academic and practitioner communities having proposed a wide varietyof models and model-selection criteria. Central to all pricing models,implicitly or explicitly, are: (i) the identity of the state vector:whether it is latent or observable and, in the latter case, whichobservable series; (ii) the law of motion (conditional distribution) ofthe state vector under the pricing measure; and (iii) the functionaldependence of the short-term interest rate on this state vector. Aprimary objective, then, of research on fixed-income pricing has beenthe selection of these ingredients to capture relevant features ofhistory, given the objectives of the modeler, while maintainingtractability, given available data and computational algorithms.Accordingly, we overview alternative conceptual approaches tofixed-income pricing, highlighting some of the tradeoffs that haveemerged in the literature between the complexity of the probabilitymodel for the state, data availability, the pricing objective, and thetractability of the resulting model.

Financial Distress and Bank Lending Relationships

Fri, 28 Sep 2001 22:58:59 GMT

Title: Financial Distress and Bank Lending Relationships

Dahiya, Sandeep; Saunders, Anthony; Srinivasan, Anand

Abstract: One of the most important risks faced by a bank is that of loan defaultby its borrowers. Existing literature has documented the negativeannouncement-period returns for lending banks when a big sovereignborrower announces a moratorium on its bank loans. In contrast, littleresearch has been undertaken that analyzes bank shareholder wealtheffects when a major corporate borrower declares default and/orbankruptcy. This paper uses a unique data set of bank loans to examinethe wealth effects on lead lending banks when their borrowers’suffer financial distress. For the 10-year period from 1987 to 1996, weexamine a sample of 71 firms that defaulted on their public debt and asample of 101 firms that filed for bankruptcy. We find a significantnegative wealth effect for the shareholders of the lead lending banks onthe announcement of bankruptcy and default by the borrowers of theirbank. We also find that the banks with relatively higher exposure to thedistressed firms have larger negative announcement-period returns,although individual loan details are not public knowledge. Thus, themarket appears to discriminate among lenders in a way not inconsistentwith a correct inference of individual borrower exposures. We alsoexamine the impact of various loan and bank characteristics on themagnitude of announcement returns. We find that the existence of a pastlending relationship with the distressed firm results in larger wealthdeclines for the bank shareholders. Finally, we find that financialdistress also has a significantly negative effect on borrower’s returns.

Factors Affecting the Valuation of Corporate Bonds

Wed, 25 Oct 2000 22:58:59 GMT

Title: Factors Affecting the Valuation of Corporate Bonds

Elton, Edwin J.; Gruber, Martin J.; Agrawal, Deepak; Mann, Christopher

Abstract: The valuation of corporate debt is an important issue in asset pricing.While there has been an enormous amount of theoretical modeling ofcorporate bond prices, there has been relatively little empiricaltesting of these models 1 . Recently there has been extensivedevelopment of rating based reduced form models. These models take as apremise that bonds when grouped by ratings are homogeneous with respectto risk. For each risk group the models require estimates of severalcharacteristics such as the spot yield curve, the default probabilitiesand the recovery rate. These estimates are then used to compute thetheoretical price for each bond in the group. The purpose of thisarticle is to examine the pricing of corporate bonds when bonds aregrouped by ratings, and to investigate the ability of characteristics,in addition to bond ratings, to improve the performance of rating basedmodels. Most of our testing will be conducted in models which are in thespirit of the theory developed by Duffie and Singleton (1997) and Duffie(1999) The paper is divided into three sections. In the first section,we discuss various reduced form models that have been suggested in theliterature. In the second section we examine how well standardclassifications serve as a metric for forming homogeneous groups. Inthis section we show that using standard classifications results inerrors being systematically related to specific bond characteristics.Finally, in the last section we take account of these specific bondcharacteristics in our estimation procedure for determining spot pricesand show how this lead to improved estimates of corporate bond prices.

Factors Affecting the Valuation of Corporate Bonds

Wed, 25 Oct 2000 22:58:59 GMT

Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indices

Thu, 29 May 2003 22:58:59 GMT

Title: Explaining Credit Spread Changes: Some New Evidence from Option-AdjustedSpreads of Bond Indices

Huang, Jing-zhi; Kong, Weipeng

Abstract: This paper revisits the question of the determinants of corporate bondcredit spreads using some new explanatory variables with both weekly andmonthly option-adjusted credit spreads of corporate bond indices fromMerrill Lynch. We find that among the new variables, the interest ratehistorical volatility, the Russell 2000 index historical returnvolatility and Conference Board leading and coincident economic indiceshave significant power in explaining credit spread changes, especiallyfor high yield bond indices. Furthermore, these four variables plus theinterest rate level, the yield curve slope, the Russell 2000 indexreturn, and the Fama-French [1996] high-minus-low factor return couldexplain more than 40% of credit spread changes in 5 out of 9rating/maturity indices. In particular, these variables could explain67.68% of the variation in B rated index credit spreads and 60.82% ofthe variation in BB rated index credit spreads. The overall explanatorypower on credit spread changes achieved here is a notable improvementover most previous studies using either option-adjusted index spreads orindividual corporate bond spreads. Our analysis confirms that high-yieldcredit spread changes are more closely related with equity marketfactors and also provides evidence in favor of incorporatingmacroeconomic risk factors into credit risk models.

Estimating Risk Parameters

Thu, 29 Oct 1998 22:58:59 GMT

Title: Estimating Risk Parameters

Damodaran, Aswath

Abstract: Over the last three decades, the capital asset pricing model hasoccupied a central and often controversial place in most corporatefinance analysts’ tool chests. The model requires three inputs tocompute expected returns – a riskfree rate, a beta for an assetand an expected risk premium for the market portfolio (over and abovethe riskfree rate). Betas are estimated, by most practitioners, byregressing returns on an asset against a stock index, with the slope ofthe regression being the beta of the asset. In this paper, we attempt toshow the flaws in regression betas, especially for companies in emergingmarkets. We argue for an alternate approach that allows us to estimate abeta that reflect the current business mix and financial leverage of a firm.

Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors

Sun, 07 Dec 2003 22:58:59 GMT

Title: Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors

Sangvinatsos, Antonios; Wachter, Jessica

Abstract: We consider the consumption and portfolio choice problem of a long-runinvestor when the term structure is affine and when the investor hasaccess to nominal bonds and a stock portfolio. In the presence ofunhedgeable inflation risk, there exist multiple pricing kernels thatproduce the same bond prices, but a unique pricing kernel equal to themarginal utility of the investor. We apply our method to a three-factorGaussian model with a time-varying price of risk that captures thefailure of the expectations hypothesis seen in the data. We extend thismodel to account for time-varying expected inflation, and estimate themodel with both inflation and term structure data. The estimates implythat the bond portfolio for the long-run investor looks very differentfrom the portfolio of a mean-variance optimizer. In particular, thedesire to hedge changes in term premia generates large hedging demandsfor long-term bonds.

Defaults and Returns on High Yield Bonds: The Year 2002 in Review and the Market Outlook

Wed, 29 Jan 2003 22:58:59 GMT

Title: Defaults and Returns on High Yield Bonds: The Year 2002 in Review andthe Market Outlook

Altman, Edward I.; Bana, Gaurav

Abstract: The year 2002 was remarkably difficult on many fronts for most financialmarkets. For the high yield bond market, it was again a year of recordamounts of defaults which contributed to low recovery rates and slightlynegative absolute returns. The default rate registered a massive 12.8%,based on $757 billion outstanding. Despite these record default totalsand rates, the market’s decline was orderly with little panic andactually ended the year with reduced defaults and highly positivereturns in the fourth quarter. Default amounts registered its fourthconsecutive record year and almost topped $100 billion ($97.9 billion)for the first time. This total was more than 52% higher than lastyear’s record. Combined with a near record low recovery rate of25 cents on the dollar, weighed down by Telecom’s average recoveryrate of 16%, loss rates from defaults reached record levels of about 10%-- even adjusted for fallen angel default recoveries. The pervasiveinfluence of WorldCom’s massive default had a profound effect onboth the default and recovery rates. Without WorldCom, the year’sdefault rate would have been 9.27% -- a differential of about 3.5%.This report documents and comments upon the high yield bondmarket’s risk and return performance over the period 1971-2002.We will present traditional, dollar-denominated default rates as well asour own mortality rate statistics. Default rate analysis will becomplemented by discussion on corporate bankruptcies and the immenseimpact of fallen angels on the high yield market. We conclude with ourannual estimate of the size of the distressed debt market and ourforecast for defaults in 2003. Our analysis will include an update onour default recovery forecasting model which was extremely accurate inestimating 2002’s recovery rate of about 25%. Based on the fourthquarter’s reduction in default rate to 1.82% and ouraging-mortality conceptual framework, we are predicting a reduction inthe dollar denominated default rate to 7.5-8.0%, as much as 5% less than2002 (but still far above the average rate). This should help provide amore attractive environment for high yield debt new issues and returnsin 2003. In 2002, there was $65.6 billion in new high yield bondissuance, down from 2001’s $88.2 billion. We expect new issuancein 2003 to escalate unless the economic/political scene motivatesanother flight to quality in our financial markets.

Defaults and Returns on High Yield Bonds: Analysis Through September 30, 2002

Sat, 28 Sep 2002 22:58:59 GMT

Title: Defaults and Returns on High Yield Bonds: Analysis Through September 30, 2002

Altman, Edward I.; Bana, Gaurav

Abstract: The third-quarter 2002 default rate for high yield bonds was 4.95%,based on $37.48 billion of defaults. The quarterly default rate is thehighest in history, surpassing the first quarter of 1991 rate of 4.80%.One massive default, WorldCom, accounted for $28.30 billion of defaults(76%). Without WorldCom, the third quarter default rate would have onlybeen 1.2%. The dollar weighted default rate for the first three quartershas already broken the record for a single calendar year reaching10.98%. And, the latest four-quarters’ default rate of 15.01% hasalso set a record. Again, WorldCom’s huge default contributedabout 4% of this record total. The persistently high default ratethrough the third quarter has resulted in a near record yield spread of10.10% -- second only to 1990’s 10.50%. The current yield spreadis more than 5% above the historical average. We believe the defaultrate has peaked in Q3-2002 and depending on the size of the decline, webelieve the huge yield spread could reflect an over-sold market.Counting WorldCom ($46.0 billion in liabilities), there were more than$197 billion in liabilities of firms which filed for Chapter 11protection through the third quarter and 26 firms had liabilitiesgreater than $1 billion. The count was 22 firms through the first-halfof the year, so the third-quarter number was "only" four,including WorldCom. There were 39 of such firms in 2001 - - a record year.

Defaults and Returns in the High Yield Bond Market: The Year 2003 in Review and Market Outlook

Thu, 29 Jan 2004 22:58:59 GMT

Title: Defaults and Returns in the High Yield Bond Market: The Year 2003 inReview and Market Outlook

Altman, Edward I.; Fanjul, Gonzalo

Abstract: High yield bond defaults in 2003 declined significantly from record 2002levels closing the year at $38.5 billion for a default rate of 4.66%.The fourth quarter’s rate of 0.36% was the lowest quarterly ratesince the fourth quarter of 1997. The default loss rate for 2003 alsodeclined to just 2.76% based on a weighted average recovery rate ofabout 45% -- a major improvement from the 25% levels of the priorseveral years. Fourteen of the 86 defaulting companies had issues thatwere investment grade sometime prior to default. These fallen angelsaccounted for 33% of defaulting issues and 46.3% of the defaulted volumein 2003. The high-yield bond market returned an impressive 30.62% forthe year, the third highest one-year return since 1978 (when we firstbegan tracking returns). The return spread over ten-year US Treasurieswas a record high 29.4%, bringing the historic average annual returnspread to 2.22% per year. The concurrent yield spread at year-end fellto 3.74%, the lowest year-end figure since 1997 and 4.82% less than oneyear ago. New issues in 2003 recorded a near record level of $137.4billion; the vast majority was used for refinancing existing loan andbond issues. Based on our mortality rate methodology and assumingdifferent measures of credit risk of recent new issuance, we expectdefault rates to continue their decline in 2004 to between 3.2% - 3.8%,with rates increasing in 2005 to above 4.0%.

Defaults & Returns on High Yield Bonds: Analysis Through 1998 and Default Outlook for 1999-2001

Thu, 29 Oct 1998 22:58:59 GMT

Title: Defaults & Returns on High Yield Bonds: Analysis Through 1998 andDefault Outlook for 1999-2001

Altman, Edward I.; Cooke, Diane; Kishore, Vellore

Abstract: Nineteen-ninety-eight was a mixed performance year for the high yieldbond market in the United States , with much below average returns andspreads over default-risk-free Treasury Bonds but continued relativelylow default rates and losses and another record year of new insurance.Returns and new insurance were excellent through the first seven monthsof the year but returns reversed and new issues dried up, temporarily,in the wake of August's Russians default and the emerging marketturmoil, causing another short-term flight to quality. Returns in 1998on high yield bonds in the U.S. were slightly above 4.0% for the entireyear, about 8.5% lower than historical averages. Return spreads alsowere much below average (-8.7%). The default rate was again relativelylow, 1.60%, and losses from default 1.1%. Despite 1998's low relativereturn, net returns (after deducting losses from defaults) over the lasttwo decades continue to show a compound result over 12% per year andspreads over U.S. Treasuries of over 2.5% per year. New insurance ofhigh yield debt in 1998 totaled a record $152 billion, with $120 billionof the total in the first seven and a half months. This reportdocuments the high yield debt market's risk and return performance bypresenting default and morality statistics and providing a matrix ofaverage returns and other performance statistics over relevant periodsof the market's evolution. Our analysis covers the period 1971-1998 fordefaults and 1978-1998 for returns. In addition, we present our annualforecast of expected defaults for the next three years (1999-2001). Twoother reports, published by the NYU Salomon Center, comprehensivelydocument the performance of defaulted public bonds and bank loans andthe default rate experience on syndicated bank loans.

Default Recovery Rates in Credit Risk Modeling: A Review of the Literature and Empirical Evidence

Fri, 28 Nov 2003 22:58:59 GMT

Title: Default Recovery Rates in Credit Risk Modeling: A Review of theLiterature and Empirical Evidence

Altman, Edward; Resti, Andrea; Sironi, Andrea

Abstract: Evidence from many countries in recent years suggests that collateralvalues and recovery rates on corporate defaults can be volatile and,moreover, that they tend to go down just when the number of defaultsgoes up in economic downturns. This link between recovery rates anddefault rates has traditionally been neglected by credit risk models, asmost of them focused on default risk and adopted static lossassumptions, treating the recovery rate either as a constant parameteror as a stochastic variable independent from the probability of default.This traditional focus on default analysis has been partly reversed bythe recent significant increase in the number of studies dedicated tothe subject of recovery rate estimation and the relationship betweendefault and recovery rates. This paper presents a detailed review of theway credit risk models, developed during the last thirty years, treatthe recovery rate and, more specifically, its relationship with theprobability of default of an obligor. Recent empirical evidenceconcerning this issue is also presented and discussed.

Credit Risk and the Yen Interest Rate Swap Market

Wed, 28 Jun 2000 22:58:59 GMT

Title: Credit Risk and the Yen Interest Rate Swap Market

Eom, Young Ho; Subrahmanyam, Marti G.; Uno, Jun

Abstract: In this paper, we investigate the pricing of Japanese yen interest rateswaps during the period 1990-96. We obtain measures of the spreads ofthe swap rates over comparable Japanese Government Bonds (JGBs) fordifferent maturities and analyze the relationship between the swapspreads and credit risk variables. Our empirical results in the yenswap market indicate that: 1) the commonly-used assumption of lognormaldefault-free interest rates and swap spreads is strongly rejected by thedata, 2) the term structure of swap spreads displays a humped-shape, and3) the shocks in the yen swap spread are negatively correlated with theshocks in the comparable default-free spot rates, especially for longermaturities. Our analysis also indicates that yen swap spreads behavedvery differently from the credit spreads on Japanese corporate bonds inthe early nineties. In contrast to Japanese corporate bonds, we findthat the yen swap spread is also significantly related to proxies forthe long-term credit risk factor. Furthermore, the swap spread isnegatively related to the level and slope of the term structure andpositively related to the curvature, indicating that the credit"optionality" is priced in the swap rate. Thus, overall, theyen swap market was sensitive to credit risk during the period of our study.

Credit Risk Analysis and Security Design

Tue, 29 Oct 2002 22:58:59 GMT

Title: Credit Risk Analysis and Security Design

Inderst, Roman; Müller, Holger M.

Abstract: This paper considers the potential cost of subjective judgment anddiscretion in credit decisions. We show that subjectivity and discretionin the evaluation of borrowers create an incentive problem on the partof the lender. The lender’s incentives to accept or reject aborrower depend only on the value of her own claims, not on the totalvalue of the project. Unless the lender obtains the full NPV her creditdecision is too conservative, i.e., she uses too high a hurdle rate.Given this problem we show that the unique optimal security is standarddebt. Among all securities debt is the one that makes the lender theleast conservative, thus providing her with optimal incentives to tradeotype-1 and type-2 errors. Among other things, this suggests that thecommon folk wisdom whereby giving banks equity makes them less cautiousin their credit decisions is generally not correct.

CREDIT RATINGS AND THE BIS REFORM AGENDA

Fri, 09 Feb 2001 22:58:59 GMT

Title: CREDIT RATINGS AND THE BIS REFORM AGENDA

Altman, Edward; Saunders, Anthony

Abstract: This is an updated and revised paper from the authors’ report on“An Analysis and Critique of the BIS Proposal on Capital Adequacyand Ratings” [S-CDM-00-02] (submitted to the BIS and published inthe Journal of Banking & Finance 25:1 January, 2001). This paper wasfirst prepared for the NYU Salomon Center/University of Marylandresearch project on “The Role of Credit Reporting Systems in theInternational Economy,” sponsored by the Center for InternationalPolitical Economy. It was prepared for the project’s conference inWashington D.C. on March 1-2, 2001 at the headquarters of the World Bank.

Credit Rating Dynamics and Markov Mixture Models

Mon, 28 Jun 2004 22:58:59 GMT

Title: Credit Rating Dynamics and Markov Mixture Models

Frydman, Halina; Schuermann, Til

Abstract: Despite overwhelming evidence to the contrary, credit migrationmatrices, used in many credit risk and pricing applications, aretypically assumed to be generated by a simple Markov process. In thispaper we propose a parsimonious model that is a mixture of (two) Markovchains. We estimate this model using credit rating histories and showthat the mixture model statistically dominates the simple Markov modeland that the differences between two models can be economicallymeaningful. The non-Markov property of our model implies that the futuredistribution of a firm's ratings depends not only on its current ratingbut also on its past rating history. Indeed we find that two firms withidentical credit ratings can have substantially different transitionprobability vectors.

CORPORATE DISTRESS PREDICTION MODELS IN A TURBULENT ECONOMIC AND BASEL II ENVIRONMENT

Thu, 29 Aug 2002 22:58:59 GMT

Title: CORPORATE DISTRESS PREDICTION MODELS IN A TURBULENT ECONOMIC AND BASELII ENVIRONMENT

Altman, Edward I.

Abstract: This paper discusses two of the primary motivating influences on therecent development/revisions of credit scoring models, - the importantimplications of Basel II’s proposed capital requirements on creditassets and the enormous amounts and rates of defaults and bankruptciesin the United States in 2001-2002. Two of the more prominent creditscoring techniques, our Z-Score and KMV’s EDF models, arereviewed. Both models are assessed with respect to default probabilitiesin general and in particular to the infamous Enron and WorldCom debaclesin particular. In order to be effective, these and other credit riskmodels should be utilized by firms with a sincere credit risk culture,observant of the fact that they are best used as an additional tool, notthe sole decision making criteria, in the credit and security analyst process.

Corporate Bonds: Valuation, Hedging, and Optimal call and Default Policies

Thu, 17 Feb 2000 22:58:59 GMT

Title: Corporate Bonds: Valuation, Hedging, and Optimal call and Default Policies

Acharya, Viral V.; Carpenter, Jennifer N.

Abstract: This paper studies the valuation and risk management of callable,defaultable bonds when both interest rates and firm value are stochasticand when the issuer follows optimal call and default policies. Sinceinterest rate sensitivity is low when call is imminent and firm valuesensitivity is high when default is imminent, characterizing theissuer's call and default policies is essential to understandingcorporate bond risk management. We develop analytical results on optimalcall and default rules and use them to explain the dynamics of a hedgingstrategy for corporate bonds using Treasury bonds and issuer equity. Toclarify the interaction between the issuer's embedded call and defaultoptions, we compare the callable defaultable bond to its pure callableand pure defaultable counterparts. Each bond's embedded option is a callon a riskless, noncallable host bond, distinguished only by its strikeprice. This generalized call option perspective generates intuition fora variety of results. For instance, spreads on all bonds, not justcallables, narrow with interest rates; a decline in rates can trigger adefault; a call provision can increase the duration of a risky bond; acall provision increases equity's sensitivity to firm value, mitigatingthe underinvestment problem identified by Myers (1977).

Conflicts of Interest and Market Discipline Among Financial Services Firms

Sun, 28 Sep 2003 22:58:59 GMT

Title: Conflicts of Interest and Market Discipline Among Financial Services Firms

Walter, Ingo

Abstract: There has been substantial public and regulatory attention of late toapparent exploitation of conflicts of interest involving financialservices firms based on financial market imperfections and asymmetricinformation. This paper proposes a workable taxonomy of conflicts ofinterest in financial services firms, and links it to the nature andscope of activities conducted by such firms, including possiblecompounding of interest-conflicts in multifunctional clientrelationships. It lays out the conditions that either encourage orconstrain exploitation of conflicts of interest, focusing in particularon the role of information asymmetries and market discipline, includingthe shareholder-impact of litigation and regulatory initiatives.External regulation and market discipline are viewed as both complementsand substitutes – market discipline can leverage the impact ofexternal regulatory sanctions, while improving its granularity thoughdetailed management initiatives applied under threat of marketdiscipline. At the same time, market discipline may help obviate theneed for some types of external control of conflict of interest exploitation.

Commercial Bank Underwriting of Credit-Enhanced Bonds: Are there Certification Benefits to the Issuer?

Tue, 26 Feb 2002 22:58:59 GMT

Title: Commercial Bank Underwriting of Credit-Enhanced Bonds: Are thereCertification Benefits to the Issuer?

Saunders, Anthony; Stover, Roger D.

Abstract: Recent studies have expanded the commercial bank certificationhypothesis to include banks acting in an underwriting capacity. Thispaper further develops that research by focusing on the industrialrevenue bond market in which banks have the unique opportunity tosimultaneously act as both credit guarantor and underwriter. Whenexplicitly allowing for bank-issued standby letters of credit(guarantees), we find significantly greater yield spreads for thosebonds underwritten by commercial banks compared to bonds underwritten byinvestment banks. Overall, no net benefit appears to accrue to the bondissuer when attempting to achieve joint (or double) certificationbenefits by employing commercial banks as both credit guarantor andunderwriters except in the special case where the same bank acts as bothguarantor and underwriter. This limited certification effect is furthervalidated when the credit quality of participating banks is accountedfor. This result is consistent with an "economy of scope" inmonitoring and reusing information.

Commercial Bank Underwriting of Credit-Enhanced Bonds: Are there Benefits to the Issuer?

Sun, 22 Jul 2001 22:58:59 GMT

Title: Commercial Bank Underwriting of Credit-Enhanced Bonds: Are thereBenefits to the Issuer?

Saunders, Anthony; Stover, Roger D.

Abstract: Recent studies have expanded the commercial bank certificationhypothesis to include banks acting in an underwriting capacity. Thispaper further develops that research by focusing on the industrialrevenue bond market in which banks have the unique opportunity tosimultaneously act as both credit guarantor and underwriter. Whenexplicitly allowing for bank-issued standby letters of credit(guarantees), we find significantly greater yield spreads for thosebonds underwritten by commercial banks compared to bonds underwritten byinvestment banks. Overall, no net benefit appears to accrue to the bondissuer when attempting to achieve joint (or double) certificationbenefits by employing commercial banks as both credit guarantor andunderwriters except in the special case where the same bank acts as bothguarantor and underwriter. This latter result is consistent with an"economy of scope" in monitoring and reusing information.

Capital Structure with Asymmetric Information about Value and Risk: Theory and Empirical Analysis

Sun, 02 May 2004 22:58:59 GMT

Title: Capital Structure with Asymmetric Information about Value and Risk:Theory and Empirical Analysis

Halov, Nikolay; Heider, Florian

Abstract: The paper presents a simple model arguing that the pecking order theoryis an extreme when there is only asymmetric information about value. Weshow how asymmetric information about both, value and risk, transformsthe adverse selection logic underlying the pecking order into a generaltheory of capital structure that accounts for both debt and equityissues. The model predicts that firms issue more equity and less debt ifthere is more asymmetric information about risk relative to value. Wefind robust empirical support for the prediction and document a stronglink between risk and capital structure in a large unbalanced panel ofpublicly traded US firms from 1971 to 2001.

BIRTH OF THE FEDERAL RESERVE: CRISIS IN THE WOMB

Sun, 28 Sep 2003 22:58:59 GMT

Title: BIRTH OF THE FEDERAL RESERVE: CRISIS IN THE WOMB

Silber, William L.

Abstract: The outbreak of World War I shut the New York Stock Exchange for morethan four months. The conventional explanation maintains that theclosure prevented a collapse in stock prices that threatened arepetition of the Panic of 1907. This paper shows that the WilsonAdministration encouraged the suspension of trading to pave the way forlaunching the Federal Reserve System, which was in the process of beingborn. Closing the Exchange helped to forestall an outflow of gold.Federal Reserve insiders considered an adequate stock of gold crucial tothe success of the new monetary system.

AN INTEGRATED PRICING MODEL FOR DEFAULTABLE LOANS AND BONDS

Wed, 29 Jan 2003 22:58:59 GMT

Title: AN INTEGRATED PRICING MODEL FOR DEFAULTABLE LOANS AND BONDS

Altman, Edward I.; Onorato, Mario

Abstract: In recent years, credit risk has played a key role in risk managementissues. Practitioners, academics and regulators have been fully involvedin the process of developing, studying and analyzing credit risk modelsin order to find the elements which characterize a sound risk managementsystem. In this paper we present an integrated model, based on a reducedpricing approach, for market and credit risk. Its main features arethose of being mark to market and that the spread term structure byrating class is contingent on the seniority of debt within anarbitrage-free framework. We introduce issues such as, the integrationof market and credit risk, the use of stochastic recovery rates andrecovery by seniority. Moreover, we will characterize default risk byestimating migration risk through a "mortality rate",actuarial based, approach. The resultant probabilities will be the basefor determining multi-period risk-neutral transition probability thatallow pricing of risky debt in the trading and banking book.

An Econometric Model of Credit Spreads with Rebalancing, ARCH and Jump Effects

Mon, 07 Apr 2003 22:58:59 GMT

Title: An Econometric Model of Credit Spreads with Rebalancing, ARCH and Jump Effects

Bierens, Herman; Huang, Jing-zhi; Kong, Weipeng

Abstract: In this paper, we examine the dynamic behavior of credit spreads oncorporate bond portfolios. We propose an econometric model of creditspreads that incorporates portfolio rebalancing, the near unit rootproperty of spreads, the autocorrelation in spread changes, the ARCHconditional heteroscedasticity, jumps, and lagged market factors. Inparticular, our model is the first that takes into account explicitlythe impact of rebalancing and yields estimates of the absorbing boundson credit spreads induced by such rebalancing. We apply our model tonine Merrill Lynch daily series of option-adjusted spreads with ratingsfrom AAA to C for the period January 1997 through August 2002. We findno evidence of mean reversion in these credit-spread series over oursample period. However, we find ample evidence of both the ARCH effectand jumps in the data especially in the investment-grade credit spreadindices. Incorporating jumps into the ARCH type conditional varianceresults in significant improvements in model diagnostic tests. We alsofind that while log spread variations depend on both the lagged Russell2000 index return and lagged changes in the slope of the yield curve,the time-varying jump intensity of log credit spreads is correlated withthe lagged stock market volatility. Finally, our results indicate theARCH-jump specification outperforms the ARCH specification in theout-of-sample, one-step-ahead forecast of credit spreads.

A Survey of Cyclical Effects in Credit Risk Measurement Models

Sun, 28 Apr 2002 22:58:59 GMT

Title: A Survey of Cyclical Effects in Credit Risk Measurement Models

Allen, Linda; Saunders, Anthony

Abstract: We survey both academic and proprietary models to examine howmacroeconomic and systematic risk effects are incorporated into measuresof credit risk exposure. Many models consider the correlation betweenthe probability of default (PD) and cyclical factors. Few models adjustloss rates (loss given default) to reflect cyclical effects. We findthat the possibility of systematic correlation between PD and LGD isalso neglected in currently available models.

A Simple Model for Pricing Securities with Equity, Interest-Rate, and Default Risk

Fri, 27 Feb 2004 22:58:59 GMT

Title: A Simple Model for Pricing Securities with Equity, Interest-Rate, andDefault Risk

Das, Sanjiv R.; Sundaram, Rangarajan K.

Abstract: We develop a model for pricing derivative and hybrid securities whosevalue may depend on different sources of risk, namely, equity,interest-rate, and default risks. In addition to valuing such securitiesthe framework is also useful for extracting probabilities of default(PD) functions from market data. Our model is not based on thestochastic process for the value of the firm [which is unobservable],but on the stochastic process for interest rates and the equity price,which are observable. The model comprises a risk-neutral setting inwhich the joint process of interest rates and equity are modeledtogether with the default conditions for security payoffs. The model isembedded on a recombining lattice which makes implementation of thepricing scheme feasible with polynomial complexity. We present a simpleapproach to calibration of the model to market observable data. Theframework is shown to nest many familiar models as special cases. Themodel is extensible to handling correlated default risk and may be usedto value distressed convertible bonds, debt-equity swaps, and creditportfolio products such as CDOs. We present several numerical andcalibration examples to demonstrate the applicability and implementationof our approach.

A Model of Optimal Capital Structure with Stochastic Interest Rates

Sun, 16 Feb 2003 22:58:59 GMT

Title: A Model of Optimal Capital Structure with Stochastic Interest Rates

Huang, Jing-zhi; Ju, Nengjiu; Ou-Yang, Hui

Abstract: This paper develops a model of optimal capital structure with stochasticinterest rate which is assumed to follow a mean-reverting process.Closed-form solutions are obtained for both the value of the firm andthe value of its risky debt. The paper finds that the current level andthe long-run mean of the interest rate process play distinctive roles inour integrated model. The current level of the interest rate is criticalin the pricing of risky bonds, while the long-run mean plays a key rolein the determination of a firm’s optimal capital structure such asthe optimal coupon rate and leverage ratio. Our findings demonstratethat a model of optimal capital structure with a constant interest ratecannot price risky bonds and determine the optimal capital structuresimultaneously in a satisfactory manner. Furthermore, our numericalresults indicate that the correlation between the stochastic interestrate and the asset return of a firm has little impact on thefirm’s optimal capital structure.

A MODEL OF CREDIT RISK, OPTIMAL POLICIES, AND ASSET PRICES

Mon, 29 Mar 2004 22:58:59 GMT

Title: A MODEL OF CREDIT RISK, OPTIMAL POLICIES, AND ASSET PRICES

Basak, Suleyman; Shapiro, Alex

Abstract: This paper studies the optimal policies of borrowers (firms orindividuals) who may default subject to default costs, and analyzes theasset pricing implications. Borrowers defaulting under adverse economicconditions may, despite incurring default costs, emerge as wealthierthan non-borrowers or those who can default costlessly. Under manyeconomic scenarios, borrowers take on less risk exposure thannon-borrowers, and asset substitution is not pronounced. However, alarger risk exposure by borrowers may occur as well, depending on thestructure of default costs and on how debt maturity relates to theplanning horizon. In the latter case, borrowers’ default policiesrender binary options to be useful credit derivatives for lenders inhedging the credit-risk component of their assets. In our model, theasset-value dynamics are endogenously determined, and are shown toexhibit stochastic mean return and volatility in contrast to theexogenously assumed constant mean and volatility in many credit riskmodels. We consider a variety of extensions, including equilibrium,where a lower (higher) risk exposure by borrowers manifests itself in anattenuated (amplified) market volatility and risk premium, but themarket value is always higher in economic downturns, and lower inupturns, compared to an economy without the presence of credit risk.

A LENDER-BASED THEORY OF COLLATERAL

Fri, 27 Feb 2004 22:58:59 GMT

Title: A LENDER-BASED THEORY OF COLLATERAL

Inderst, Roman; Müller, Holger M.

Abstract: We offer a novel explanation for the use of collateral based on the dualfunction of banks to provide credit and assess the borrower’scredit risk. There is no moral hazard or adverse selection on the partof borrowers–the only inefficiency is that banks cannotcontractually commit to providing credit as their credit assessment issubjective. Without collateral, a bank may deny credit even if itscredit assessment suggests that the project is marginally profitable.Collateral improves the bank’s payoffs from financing suchmarginally profitable projects, thus mitigating the inefficiency arisingfrom discretionary credit decisions. Unlike models of borrower adverseselection, our model suggests that high-quality borrowers post lesscollateral than low-quality borrowers, which is consistent with theempirical evidence.