In this thesis, I imply a forward-looking systematic factor from CDO market spreads; I show that this factor is a measure of CDO market's expectation of future default correlation, and I empirically show that it is positively related to bond credit spreads. From this, I infer that corporate bond credit spreads are positively related to expected default correlation. The forward-looking factor stems from a CDO valuation model that I propose. The model assumes default can be characterized as a random event that occurs with an uncertain hazard rate that is mixture-Weibull distributed. Calibrating the model to CDO market spreads implies the model parameters. Using two and three mixing densities and data spanning January 2004 to February 2008, I show that the model calibrates to both the North American and European investment grade CDOs with negligible error. The factor I imply from the CDO market quotes is the standard deviation of the implied hazard rate density. I then show that the standard deviation of the implied hazard rate density increases as default correlation increases. This is done by characterizing firms' defaults with stochastic hazard rates that are defined by jump-diffusion processes that are correlated only through the Weiner processes, only through systematic jumps, or both. I use the models to generate CDO model spreads that are used to imply mixture-Weibull hazard rate densities. In addition, I provide evidence that the implied hazard rate density standard deviation has time variation that is independent to that of other common systematic factors. Lastly, I show that bond credit spreads are positively correlated with the standard deviation of the implied hazard rate density, and I conclude that credit spreads are positively related to expected default correlation. I provide evidence that firms' credit spreads are decreasing in firm diversity; that credit spread sensitivity to default correlation is decreasing in firm equity option implied volatility and decreasing in firm diversity; and that the variation in high credit quality bond spreads is predominantly explained by systematic factors whereas the variation in low credit quality bond spreads is explained by systematic and idiosyncratic factors.

In this thesis, I imply a forward-looking systematic factor from CDO market spreads; I show that this factor is a measure of CDO market's expectation of future default correlation, and I empirically show that it is positively related to bond credit spreads. From this, I infer that corporate bond credit spreads are positively related to expected default correlation. The forward-looking factor stems from a CDO valuation model that I propose. The model assumes default can be characterized as a random event that occurs with an uncertain hazard rate that is mixture-Weibull distributed. Calibrating the model to CDO market spreads implies the model parameters. Using two and three mixing densities and data spanning January 2004 to February 2008, I show that the model calibrates to both the North American and European investment grade CDOs with negligible error. The factor I imply from the CDO market quotes is the standard deviation of the implied hazard rate density. I then show that the standard deviation of the implied hazard rate density increases as default correlation increases. This is done by characterizing firms' defaults with stochastic hazard rates that are defined by jump-diffusion processes that are correlated only through the Weiner processes, only through systematic jumps, or both. I use the models to generate CDO model spreads that are used to imply mixture-Weibull hazard rate densities. In addition, I provide evidence that the implied hazard rate density standard deviation has time variation that is independent to that of other common systematic factors. Lastly, I show that bond credit spreads are positively correlated with the standard deviation of the implied hazard rate density, and I conclude that credit spreads are positively related to expected default correlation. I provide evidence that firms' credit spreads are decreasing in firm diversity; that credit spread sensitivity to default correlation is decreasing in firm equity option implied volatility and decreasing in firm diversity; and that the variation in high credit quality bond spreads is predominantly explained by systematic factors whereas the variation in low credit quality bond spreads is explained by systematic and idiosyncratic factors.

This thesis deals with various issues regarding determinants of US corporate credit spreads. These spreads are estimated as the difference between yields to maturity for corporate bonds and default-free instruments (Treasury bonds) of the same maturity. Corporate credit spreads are considered as measures of default risk. However, the premium required by investors for holding risky rather than risk-free bonds will incorporate a compensation not only for the default risk but also for other factors related to corporate bonds such as market liquidity or tax differential between corporate and Treasury bonds. In this study we firstly examine the relationship between bond ratings and credit spreads given that bond rating changes are expected to carry some informational value for debt investors. The findings indicate that bond ratings generally carry some informational value for corporate bond investors. The Granger causal relationship is more evident for negative watch lists and during periods of uncertainty in financial markets. In line with previous studies, our results suggest that changes in credit spreads are significantly related to interest rate levels, systematic risk factors (Fama and French) factors and equity returns.

Do corporate bond spreads reflect fear of debt deflation? Most corporate bonds have fixed nominal face values, so unexpectedly low inflation raises firms' real debt burdens and increases default risk. The first chapter develops a real business cycle model with time-varying inflation risk and optimal, but infrequent, capital structure choice. In this model, more volatile or more procyclical inflation lead to quantitatively important credit spread increases. This is true even with inflation volatility as moderate as that in developed economies since 1970. Intuitively, this result obtains because inflation persistence generates large uncertainty about the price level at long maturities and because firms cannot adjust their capital structure immediately. We find strong empirical support for our model predictions in a panel of six developed economies. Both inflation volatility and the inflation-stock return correlation have varied substantially over time and across countries. They jointly explain as much variation in credit spreads as do equity volatility and the dividend-price ratio. Credit spreads rise by 15 basis points if either inflation volatility or the inflation-stock return correlation increases by one standard deviation. Firms counteract higher debt financing costs by adjusting their capital structure in times of higher inflation uncertainty. The second chapter empirically decomposes excess return predictability in inflation-indexed and nominal government bonds into liquidity, market segmentation, real interest rate risk and inflation risk. This chapter finds evidence for time-varying liquidity premia in Treasury Inflation Protected Securities (TIPS) and for time-varying liquidity premia in TIPS and for time-varying inflation risk premia in nominal bonds. The third chapter develops a pre-test for weak instruments in linear instrumental variable regression that is robust to heteroskedasticity and autocorrelation. Our test statistic is a scaled version of the regular first-stage F statistic. The critical values depend on the long-run variance-covariance matrix of the first stage. We apply our pre-test to the instrumental variable estimation of the Elasticity of Intertemporal Substitution and find that instruments previously considered not to be weak do not exceed our threshold.

Credit derivative market has experienced an exponential growth during the last 10 years with credit default swap (CDS) as an undoubted leader within this group. CDS contract is a bilateral agreement where the seller of the financial instrument provides the buyer the right to get reimbursed in case of the default in exchange for a continuous payment expressed as a CDS spread multiplied by the notional amount of the underlying debt. Originally invented to transfer the credit risk from the risk-averse investor to that one who is more prone to take on an additional risk, recently the instrument has been actively employed by the speculators betting on the financial health of the underlying obligation. It is believed that CDS contributed to the recent turmoil on financial markets and served as a weapon of mass destruction exaggerating the systematic risk. However, the latest attempts to curb the destructive force of the credit derivative for the market by means of enhancing the regulation over the instrument, bringing it on the stock-exchange and solving the transparency issue might approve CDS in the face of investor who seeks to diminish the risk of his financial portfolio. In our thesis we provide empirical evidence of CDS ability to fulfil the diversification function in the portfolio of such credit sensitive claims as bonds and stocks. Our data for the empirical analysis consist of 12 European companies whose debt underlies the most frequently traded single-name CDS with the maturity of 5 years. Through multivariate vector autoregressive models we have tested the intertemporal relation between stock returns, CDS and bond spreads changes as well as the magnitude of this relation depending on the stock market state.   The results we have achieved for our sample are the following: 1) stock returns are mainly negatively related to the CDS and bond spread changes; 2) stock returns are the least affected by both credit spread changes, whereas changes in bond spreads are the best explained by the stock and CDS market movements; 3) the strength of the relation between three variables differs over the time: the relationship between stock returns and CDS spreads is the most dominant during the pre and post-crisis periods, while during the financial crisis time the relation between stock returns and bond spread changes as well as that of between both credit spreads comes to the foreground.   The above described relations between the three markets serve as a proof of the possibility to work out diversification strategies employing CDS. During the time of turbulence on the markets the investor may exert bigger diversification gains with the help of CDS. Thus, in spite of all the recent blame of the instrument from the investor perspective it is still remains one of the sources of profit.

This work empirically examines six structural models of the term structure of credit risk spreads: Merton (1974), Longstaff & Schwartz (1995) (with and without stochastic interest rates), Leland & Toft (1996), Collin-Dufresne & Goldstein (2001), and a constant elasticity of variance model. The conventional approach to testing structural models has involved the use of observable data to proxy the latent capital structure process, which may introduce additional specification error. This study extends Jones, Mason & Rosenfeld (1983) and Eom, Helwege & Huang (2004) by using implicit estimation of key model parameters resulting in an improved level of model fit. Unlike prior studies, the models are fitted from the observed dynamic term structure of firm-specific credit spreads, thereby providing a pure test of model specification. The models are implemented by adapting the method of Duffee (1999) to structural credit models, thereby treating the capital structure process is truly latent, and simultaneously enforcing cross-sectional and time-series model constraints. Quasi-maximum likelihood parameter estimates of the capital structure process are obtained via the extended Kalman filter applied to actual market trade prices on 32 firms and 200 bonds for the period 1994 to 2000. / We find that including an allowance for time-variation in the market liquidity premium improves model specification. A simple extension of the Merton (1974) model is found to have the greatest prediction accuracy, although all models performed with similar prediction errors. At between 28.8 to 34.4 percent, the root mean squared error of the credit spread prediction is comparable with reduced-form models. Unlike Eom, Helwege & Huang (2004) we do not find a wide dispersion in model prediction errors, as evidenced by an across model average mean absolute percentage error of 22 percent. However, in support of prior studies we find an overall tendency for slight underprediction, with the mean percentage prediction error of between -6.2 and -8.7 percent. Underprediction is greatest with short remaining bond tenor and low rating. Credit spread prediction errors across all models are non-normal, and fatter tailed than expected, with autocorrelation evident in their time series. / More complex models did not outperform the extended Merton (1974) model; in particular stochastic interest-rate and early default accompanied by an exogenous write-down rate appear to add little to model accuracy. However, the inclusion of solvency ratio mean-reversion in the Collin-Dufresne & Goldstein (2001) model results in the most realistic latent solvency dynamics as measured by its implied levels of asset volatility, default boundary level, and mean-reversion rate. The extended Merton (1974) is found to imply asset volatility levels that are too high on average when compared to observed firm equity volatility. / We find that the extended Merton (1974) and the Collin-Dufresne & Goldstein (2001) models account for approximately 43 percent of the credit spread on average. For BB rated trades, the explained proportion rises to 55 to 60 percent. For investment grade trades, our results suggest that the amount of the credit spread that is default related is approximately double the previous estimate of Huang & Huang (2003). / Finally, we find evidence that the prediction errors are related to market-wide factors exogenous to the models. The percentage prediction errors are positively related to the VIX and change in GDP, and negatively related to the Refcorp-Treasury spread.

Η τρέχουσα χρηματοπιστωτική κρίση, έδωσε τη δυνατότητα σε μεγάλο αριθμό ερευνητών να προσπαθησουν να ερμηνεύσουν συγκεκριμένες διαδικασίες που εμφανίζονται σε αυτή την κατάσταση. Ενδιαφέρον αποτελεί η σχέση μεταξύ κρατικών ομολόγων και των CDS. Η ακόλουθη εργασία θα προσπαθήσει μέσα από θεωρητική και εμπειρική ανάλυση να μελετήσει το ασφάλιστρο κινδύνου μεταξύ των δύο μέσων με τη χρήση της θεωρητικών οικονομετρικών μεθόδων. / The current financial crisis, has enabled a large number of researchers trying to interpret specific processes that occur in it. Such interest is the relationship between government bonds and CDS. The following study will attempt to theoretical and empirical study of co-movements of the spread between the two instruments with the use of theoretical econometric methods.

abstract: I study the importance of financial factors and real exchange rate shocks in explaining business cycle fluctuations, which have been considered important in the literature as non-technological factors in explaining business cycle fluctuations. In the first chapter, I study the implications of fluctuations in corporate credit spreads for business cycle fluctuations. Motivated by the fact that corporate credit spreads are countercyclical, I build a simple model in which difference in default probabilities on corporate debts leads to the spread in interest rates paid by firms. In the model, firms differ in the variance of the firm-level productivity, which is in turn linked to the difference in the default probability. The key mechanism is that an increase in the variance of productivity for risky firms relative to safe firms leads to reallocation of capital away from risky firms toward safe firms and decrease in aggregate output and productivity. I embed the above mechanism into an otherwise standard growth model, calibrate it and numerically solve for the equilibrium. In my benchmark case, I find that shocks to variance of productivity for risky and safe firms account for about 66% of fluctuations in output and TFP in the U.S. economy. In the second chapter, I study the importance of shocks to the price of imports relative to the price of final goods, led by the real exchange rate shocks, in accounting for fluctuations in output and TFP in the Korean economy during the Asian crisis of 1997-98. Using the Korean data, I calibrate a standard small open economy model with taxes and tariffs on imported goods, and simulate it. I find that shocks to the price of imports are an important source of fluctuations in Korea's output and TFP in the Korean crisis episode. In particular, in my benchmark case, shocks to the price of imports account for about 55% of the output deviation (from trend), one third of the TFP deviation and three quarters of the labor deviation in 1998. / Dissertation/Thesis / Ph.D. Economics 2011

Thesis advisor: Rui Albuquerque / Thesis advisor: Edith Hotchkiss / This dissertation consists of three essays which explorer the interaction between finance and product market choices. In the first essay, “A Corporate Finance Model with Customer Dynamics: The Leverage-Profitability Puzzle,” I develop a dynamic trade-off model with quantity and pricing decisions where firms take into account their short term impact on profitability and long term impact on customer base. The model provides a novel mechanism that explains the leverage-profitability puzzle and makes new predictions about the leverage-profitability relation that are supported in the data. In the second essay, “Quality versus Quantity Strategies in Product Markets,” we study the strategies that monopolistic competitive firms follow as they respond to traditional shocks to technology and to quality-improving shocks. Our main modeling assumption is that demand is more sensitive to quality than it is to market share. This assumption is responsible for having quality shocks be the main driving force for most of what corporations do as opposed to traditional technology shocks. It also helps explain why firms with higher quality products have higher debt and lower credit spreads. In the third essay, “Is Mismeasurement of Real Consumption Due to Product Turnover Relevant for Asset Prices?” I examine the long-standing equity premium puzzle, and test whether mismeasurement in real consumption due to ignoring quality changes embedded in product turnover has an effect. I find that the change in real consumption volatility is not sizable to account for the puzzle. / Thesis (PhD) — Boston College, 2021. / Submitted to: Boston College. Carroll School of Management. / Discipline: Finance.

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