Actual Spreads Research Articles

The Greek financial crisis: Growing imbalances and sovereign spreads

We discuss the origins of the Greek financial crisis as manifested in the growing fiscal and current-account deficits since euro-area entry in 2001. We then extend a model typically used to explain risk premia to assess the extent to which credit ratings captured these premia. Next, we estimate a cointegrating relationship between spreads and their long-term fundamental determinants and compare the spreads predicted by this estimated relationship with actual spreads. We find that spreads were significantly below what would be predicted by fundamentals from end-2004 up to the middle of 2005; by contrast, since May 2010, actual spreads have exceeded predicted spreads by some 400 basis points.

The Performance of Structural Models in Pricing Credit Spreads

Although structural models have been used as a standard in credit risk modelling for the last thirty years, there is a lack of consensus in the literature regarding their performance. This paper tests the performance of three structural models, namely the Merton (1974) model, the Collin-Dufresne and Goldstein (2001) stationary leverage ratio model and the CreditGrades™ (2002) model against the credit default swap spread using data from 2003 to 2010. We find that, consistent with existing literature, while the structural models have significant explanatory power for the cross-section of CDS spreads, all three models underpredict the observed credit spreads. The underprediction of credit spreads is not driven by any ratings categories or sector. We also show that while the three models produce spreads that are highly correlated with each other, they carry information incremental to each other. However, our evidence demonstrates that other firm specific variables: CDS liquidity, and credit rating can explain a significant part of observed credit spreads. Finally, our results indicate that the observed underpricing is driven by actual spreads reflecting additional information such as liquidity and residual credit risk, and in fact, the actual spreads are lower than implied spreads once additional credit risk and CDS liquidity information is taken into consideration.

Fiscal Policy and Interest Rates: The Role of Sovereign Default Risk

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

Heterogeneous Agents and the Indifference Pricing of Property Index Linked Swaps

Swap spreads predicted by the traditional risk-neutral valuation models are much lower than the quoted market spreads for property index linked swaps (Patel and Pereira, Journal of Real Estate Finance and Economics, 36:5–21, 2008). This paper attempts to develop a utility indifference-based model for evaluating the reservation spreads of swap receivers and payers based on the principle of expected wealth utility equivalence rather than the traditional risk-neutral argument. Under the proposed model framework, this paper addresses the determination of the swap spreads. When the incompleteness of real estate markets and heterogeneity of representative agents are taken into consideration, it is shown that the agents’ risk preferences and heterogeneous beliefs about expected future property returns are the remarkable determinants for the swap spreads. Our model also identifies market power and the settlement rules in the event of counterparty default as important factors in determining the swap spreads. Our model provides a possible interpretation for the difference between the spreads predicted by the traditional models and the actual market spreads.

The Greek financial crisis: growing imbalances and sovereign spreads

We discuss the origins of the Greek financial crisis as manifested in the growing fiscal and current-account deficits since euro-area entry in 2001. We then provide an investigation of spreads on Greek relative to German long-term government debt. Using monthly data over the period 2000 to 2010, we estimate a cointegrating relationship between spreads and their long-term fundamental determinants (including a measure of the fiscal situation, competitiveness of the Greek economy, economic activity and oil prices, reflecting the high dependence of the Greek economy on imported energy) and compare the spreads predicted by this estimated relationship with actual spreads. We find that spreads were significantly below what would be predicted by fundamentals from end-2004 up to the middle of 2005; by contrast, since May 2010, actual spreads have exceeded predicted spreads by some 400 basis points.

Heterogeneous Agents and the Indifference Pricing of Property Index Linked Swaps

Swap spreads predicted by the traditional risk-neutral valuation models are much lower than the quoted market spreads for property index linked swaps (Patel and Pereira, Journal of Real Estate Finance and Economics, 36:5-21, 2008). This paper attempts to develop a utility indifference-based model for evaluating the reservation spreads of swap receivers and payers based on the principle of expected wealth utility equivalence rather than the traditional risk-neutral argument. Under the proposed model framework, this paper addresses the determination of the swap spreads. When the incompleteness of real estate markets and heterogeneity of representative agents are taken into consideration, it is shown that heterogeneous risk preferences and beliefs about expected future property returns are the remarkable determinants for the swap spreads. Our model also identifies market power and the settlement rules in the event of counterparty default as important factors in determining the swap spreads. Our model provides a possible interpretation for the difference between the spreads predicted by the traditional models and the actual market spreads.

Do CDS Spreads Reflect Credit Risks? Evidence from UK Bank Bailouts

CDS spreads are generally considered to reflect the credit risks of their reference entities. However, CDS spreads of the major UK banks remained relatively stable in response to the recent credit crisis. We suggest that this can be explained by changes in loss given default (LGD). To obtain the result we first derive the probabilities of default from stock option prices and then determine the LGD consistent with actual CDS spreads. Our results reveal a significant decrease in the LGD of bailed out banks over the observed period in contrast to banks which were not bailed out and non-financial companies.

Calibration of the Structural Model of Corporate Bond Spreads

It has been long recognized that endogenous default probabilities cannot explain spreads between corporate and the riskless bonds. Recently, this issue has been subjected to rigorous scrutiny. Previous studies have found that for investment-grade debt, structural models explain only 15-25% of the observed spreads. On the other hand, for the high-yield debt, the structural models exaggerate actual spreads 1.5-2 times. These findings are perplexing because, while one could argue that factors other than default risk, e.g. illiquidity, can influence the spread for investment-grade bonds, it is difficult to justify the findings for junk bonds. In this paper, we offer an explanation to these puzzling results. Specifically, we account for the differential tax treatment of regular income and capital gains. In addition, we consider the uncertainty of the residual assets due bondholders, as well as the tax liability of the residual asset. We argue that the uncertainty in the claims on the future assets of the company in the case of potential default drives the spreads of an investment-grade debt as much as, if not more than, the probability of default.

A Structural Model with Counterparty Risks

The recent financial crisis has triggered more studies on counterparty risks. The theoretical research on credit risk with counterparty risks has been built based upon the reduced-form model. In contrast, this paper suggests a structural model where firm value can be reduced due to counterparty risks. After deriving a price formula for corporate bonds, we analyze the credit spreads of the corporate bonds. The effects of the counterparty risk on credit spreads are as follows: First, regardless of the level of the counterparty's credit rating, the credit spreads of a firm increase because of counterparty risks. Second, the lower the counterparty's credit rating, the stronger the impact of either the correlation between the two firms on credit spreads, or the coefficient of reduction in firm value due to counterparty risks on credit spreads. Third, compared with existing structural models, there are some cases in which the structural model with counterparty risks is more consistent with actual credit spreads. These cases depend upon the counterparty's credit rating.

Price Momentum in the New Zealand Stock Market: A Proper Accounting for Transactions Costs and Risk

We test for recently reported momentum profits in New Zealand using a practitioner technique that we have not yet seen in the academic literature. This technique simultaneously weighs returns, risk, and transactions costs at each portfolio rebalance, rather than blindly chasing returns and then accounting for risk and transactions costs after the fact. We reverse the findings of the earlier literature because our gross profits are more than fully consumed by transactions costs. Although we focus on momentum trading in New Zealand, our practitioner technique is broadly applicable to investigations of trading anomalies. We are the first to use properly bench marked and value-weighted portfolios, actual bid-ask spreads, a practitioner model of price impact, and an explicit decomposition and attribution of New Zealand momentum returns to industry and/or stock-specific sources. We find stock-specific factors dominate industry factors, and small stocks and winner stocks are better sources of momentum alpha than large stocks and loser stocks, respectively.

Risk-Arbitrage Spreads and Performance of Risk Arbitrage

This article explores the cross sectional variation in risk arbitrage spreads. Factors that are relevant to the probability of deal success (i.e., target termination fees, target resistance, target price run-up, relative size of the target, and arbitrageurs9 activity), bid revision (i.e., target9s growth opportunity), potential loss when a deal fails (i.e., bid premium and bidder9s systematic risk) and transaction costs for risk arbitrageurs (i.e., bidder9s return volatility and low priced shares) are found to be significant in developing a prediction model for risk arbitrage spreads. Risk arbitrage portfolios are created by comparing predicted arbitrage spreads with actual arbitrage spreads. The results show that deals whose actual spreads exceed the predicted spreads tend to be more attractive investments. The model may be used by risk arbitrageurs to identify attractive risk arbitrage opportunities.

Uncovered interest rate parity and the term structure

This paper examines uncovered interest rate parity (UIRP) and the expectations hypotheses of the term structure (EHTS) at both short and long horizons. The statistical evidence against UIRP is mixed and is currency- not horizon-dependent. Economically, the deviations from UIRP are less pronounced than previously documented. The evidence against the EHTS is statistically more uniform, but, economically, actual spreads and theoretical spreads (spreads constructed under the null of the EHTS) do not behave very differently, especially at long horizons. Partly because of this, the deviations from the EHTS only play a minor role in explaining deviations from UIRP at long horizons.

Trade classification algorithms for electronic communications network trades

Ellis et al. [Ellis, K., Michaely, R., O’Hara, M., 2000. The accuracy of trade classification rules: Evidence from Nasdaq. Journal of Financial and Quantitative Analysis 35 (4), 529–551] find that trade classification rules have limited success in classifying trades which execute inside the quotes. We reconfirm this result and propose an alternative algorithm to improve the classification accuracy for trades inside the quotes. This alternative algorithm improves the overall success rate for classifying trades, especially for trades that occur inside the quotes. Additionally, we show that the Lee and Ready [Lee, C., Ready, M., 1991. Inferring trade direction from intraday data. Journal of Finance 46, 733–747] and Ellis et al. (2000) trade classification algorithms provide biased estimates of the actual effective spreads and price impacts, while our algorithm provides statistically unbiased estimates of actual effective spreads and price impacts.

The Impact of Economic Capital on the Optimal Funding Equation for a Bank

This paper develops a framework for examining the impact of changes in the solvency standard of a bank (target credit rating) on the pricing of bank assets. We show that the decision of a bank to increase its solvency standard increases the price of bank assets to the extent that a bank prices its assets in order to earn a minimum return on target economic equity. However, a higher credit rating should also reduce the cost of rated-debt that a bank uses to fund its assets. We develop a loan pricing model to assess the breakeven point at which the impact of a higher solvency standard on bank asset prices is matched by the reduction in the cost of rated-debt, and compare our theoretically-derived results to actual credit spreads on bank debt rated by Standard and Poor's in order to determine the if there is an optimal credit rating for a bank. Our model uses a beta distribution to derive the capital multiplier necessary to determine the target economic equity for the bank. We vary the proportion of rated-debt funding the bank's assets. We also assess the impact of changes in the hurdle rate used to price bank assets, where the hurdle rate is varied in line with changes in the leverage of the bank. Our paper shows how target credit rating, funding mix and hurdle rates interact to determine the optimal asset mix for a bank. The paper also demonstrates the significance of the distribution assumptions used to determine the economic capital for a bank.

The Risk Premium of Corporate Bonds

The expected risk premium of corporate bonds, defined as the non-default component of corporate bond spreads, is generally related non-monotonically to credit ratings. Over the course of a complete credit cycle, the risk premium is positive and higher than actual spreads for investment-grade bonds; it rises in absolute terms as ratings deteriorate, to reach a peak in the BB sector, and then starts falling and becomes negative for CCC-rated bonds. Explanations for such a peculiar shape of the expected risk premium curve range from inefficiencies due to market segmentation to the tendency of high-yield portfolio managers to overestimate their security selection skills. For investors concerned with generating the best risk-adjusted returns, the contour of the risk premium curve promotes investment-grade bonds, but for investors willing to tolerate more volatility to achieve higher absolute returns, crossing into speculative-grade territory to gain a BB exposure is the preferred structural strategy. Finally, corporate bonds rated B and below should be considered only by investors with superior (and rare) ability either to select outperforming individual securities or to time the market accurately. <b>TOPICS:</b>Portfolio construction, performance measurement, fixed income and structured finance

Stock Market Performance and the Term Structure of Credit Spreads

AbstractWe build a structural two-factor model of default where the stock market index is one of the stochastic factors. We allow the firm to adjust its leverage ratio in response to changes in the business climate for which the past performance of the stock market index acts as a proxy. We assume that the firm's log-leverage ratio follows a mean-reverting process and that the past performance of the stock index negatively affects the firms target leverage ratio. We show that for most credit ratings our model may explain actual yield spreads better than other well-known structural credit risk models. Also, our model shows that the past performance of the stock index returns and the firm's assets beta have a significant impact on credit spreads. Hence, our model can explain why credit spreads may be different within the same credit rating groups and why spreads are lower during economic expansions and higher during recessions.

From default probabilities to credit spreads: Credit risk models do explain market prices

Credit risk models like Moody's KMV are now well established in the market and give bond managers reliable estimates of default probabilities for individual firms. Until now it has been hard to relate those probabilities to the actual credit spreads observed on the market for corporate bonds. Inspired by the existence of scaling laws in financial markets by Dacorogna et al. [2001. An Introduction to High Frequency Finance. Academic Press, San Diego, CA] and Di Matteo et al. [2005. Journal of Banking and Finance 29, 827–851] deviating from the Gaussian behavior, we develop a model that quantitatively links those default probabilities to credit spreads (market prices). The main input quantities to this study are merely industry yield data of different times to maturity and expected default frequencies (EDFs) of Moody's KMV. The empirical results of this paper clearly indicate that the model can be used to calculate approximate credit spreads (market prices) from EDFs, independent of the time to maturity and the industry sector under consideration. Moreover, the model is effective in an out-of-sample setting, it produces consistent results on the European bond market where data are scarce and can be adequately used to approximate credit spreads on the corporate level.

A Defence of the Expectations Theory as a Model of US Long Term Interest Rates

This paper re-examines the empirical content of the expectations theory of the term structure by employing the Campbell-Shiller (1987) methodology to study the behaviour of 10-year/three-month US government yield spreads. The methodology is implemented in two ways. First, theoretical spreads satisfying the expectations theory are constructed from in-sample forecasts of future changes in short rates generated from a small-scale VAR. Second, theoretical spreads are computed from out-of-sample forecasts of changes in short rates with the parameters of each VAR equation updated with a Bayesian procedure. When the procedure is restricted to give less weight to new data than would be the case with OLS estimation over an expanding sample, theoretical spreads computed from out-of-sample forecasts track actual spreads closely in pre-1979 data. This is also the case as from the start of 1984 if data from the 1979Q4-1982Q4 period of non-borrowed reserve targeting are given zero weight when estimating the parameters of the VAR. This paper was written while the author, Gregory D. Sutton, was an economist in the Monetary and Economic Department.

Borrower Credit and the Valuation of Mortgage-Backed Securities

We study the valuation of mortgage-backed securities when borrowers may have to refinance at premium rates because of their credit. The optimal refinancing strategy often results in prepayment being delayed significantly relative to traditional models. Furthermore, mortgage values can exceed par by much more than the cost of refinancing. Applying the model to an extensive sample of mortgage-backed security prices, we find that the implied credit spreads that match these prices closely parallel borrowers' actual spreads at the origination of the mortgage. These results suggest that models that incorporate borrower credit into the analysis may provide a promising alternative to the reduced-form prepayment models widely used in practice.

Relative performance of bid–ask spread estimators: Futures market evidence

The issue of transaction costs is the mainstay of the equity market microstructure. Research in the microstructure of futures markets has lagged behind. A primary reason is that futures exchanges in the U.S. do not record bid–ask quotes, requiring these costs to be imputed from transaction price data. A reliable estimator of bid–ask spreads would significantly enhance microstructure research in futures markets. Unique intraday data from the Sydney Futures Exchange (SFE) that include both transaction prices and bid–ask spreads allow us to compare bid–ask spread estimation techniques proposed in the literature against the benchmark of actual spreads in a futures market, and thus identify the best-performing estimator. To maximize relevance, we impose all the constraints that apply in U.S. futures data to perform our estimations. We find that the four bid–ask spread estimators considered significantly underestimate the actual spreads. However, simple moments-based estimators perform better in predicting spreads.