Risk Spreads Research Articles

Investigating the effects of illiquidity on credit risks via new liquidity augmented stochastic volatility jump diffusion model

Liquidity is extremely important not only within the context of financial markets but also in every scale of economic transactions. In this study, within the realm of financial markets, we configure liquidity as an independent stochastic process moderating the fluidity of all transactions and hence dynamically changing asset values. This study’s asset value process ignoring liquidity is modelled with a stochastic volatility jump-diffusion () model and that model is augmented with the incorporation of a liquidity process. The new model is called liquidity augmented stochastic volatility jump-diffusion () model. The simulation results suggest that model outperforms the models without liquidity. The application of model on the estimation of probabilities of default and credit risk spreads, using actual financial data of the selected companies listed in Dow Jones 30, reveals that neglecting the liquidity dimension in asset valuation might lead to inefficient assessments of risks. The models without an illiquidity process underestimate the probabilities of default and credit spread risks in comparison to the liquidity augmented model, model, and we believe this might have accounted for the ignored risks that caused the 2007–2008 financial crisis in a great degree.

Central bank purchases of sovereign bonds in the euro area, the random walk hypothesis, and different measures of risk

Abstract The large purchase of public sector bonds (PSPP) by the ECB constitutes an interesting special case of quantitative easing (QE). It involved the purchase of risky, peripheral euro area government bonds—not by the ECB itself but by the national central banks at their own risk. The PSPP can be assimilated into a buy-back financed with senior debt, which should reduce the value of the remaining debt. Theory thus suggests that the PSPP should not be expected to have a positive impact on peripheral risk spreads. Empirical studies try to measure the impact of the asset purchases of central banks (QE) using the market reaction at the announcement date. The announcement effects are taken to be permanent because long-term rates are assumed to follow a random walk. We show that this assumption is not warranted for the risk spreads on bonds or the credit default swaps of peripheral euro area countries.

Economic consequences of mandatory auditor reporting to bank regulators

We study the economic consequences of mandates that require bank auditors to report to bank regulators. Based on survey responses from the European Central Bank, all 28 national bank regulators within the European Union, and a review of national banking regulations, we create a novel dataset on these mandates. Exploiting the cross-sectional and time-series variation in these mandates, we find evidence that auditor reporting to bank regulators reduces bank riskiness, as measured by counterparty risk and credit spreads. We also observe a decline in problem loans and risk-weighted assets, as well as improvements in timeliness of loan loss provisions. Additional analyses suggest that mandated auditor reporting increases the effectiveness of supervisory and monitoring efforts and improves market discipline of banks. However, mandated auditor reporting comes with costs: it reduces future lending growth, risky lending, and profitability, and increases audit fees paid by shareholders.

Optimal Loan Loss Provisions and Welfare

We study the welfare implications of optimal loan loss provisions in a New Keynesian model featuring endogenous default risk and inflationary credit spreads. A unique link between provisions, credit spreads and inflation can be employed to enhance macroeconomic stability. Optimal provisions are most effective when dealing with cost-push financial shocks inherent in volatile spreads and the zero bound problem of monetary policy. Relaxing provisioning requirements following a recessionary financial disturbance consistently achieves the first-best outcome while nullifying the value of monetary policy under commitment. In contrast, deflationary demand shocks warrant an optimal rise in provisions, which inflate prices yet mildly contract output.

Research on Dynamic Analysis and Mitigation Strategies of Supply Chains under Different Disruption Risks

Due to the globalization of supply and production, supply chain management has tightened the connection between upstream and downstream enterprises. Although this modern strategy has significantly improved the efficiency of enterprises, the increasingly complex relationship between nodes also makes the supply chain system more vulnerable and unstable. As a result, the interruption of any node location in the supply chain will spread to other nodes via their diffusion, which could cause irreparable damage to the entire supply chain. Therefore, under this realistic background, only by quantitatively analyzing the specific impact on the supply chain of interruption events in different locations we can formulate active and effective mitigation strategies to achieve the effective recovery of node enterprises from interruption accidents. In this study, the system dynamics method was used to simulate the changes in inventory level, order accumulation, and profit level caused by disruption of supply, production, and sales of different node companies. The results show that the closer the node enterprise to the interruption source, the greater the risk of loss. Due to the conduction effect of the supply chain system, the risk spreads to other node enterprises. Based on the above results, corresponding mitigation strategies for enterprises to cope with different node interruptions are proposed to improve the overall efficiency and operational capabilities of the enterprise.

What Explains the Sovereign Credit Default Swap Spreads Changes in the GCC Region?

This paper aimed to investigate the drivers of sovereign credit risk spreads changes in the case of four Gulf Cooperation Council (GCC) countries, namely Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), Qatar, and Bahrain. Specifically, we explained the changes in sovereign credit default swap (hereafter SCDS) spreads at different locations of the spread distributions by three categories of explanatory variables: global uncertainty factors, local financial variables, and global financial market variables. Using weekly data from 5 April 2013, to 17 January 2020, and the quantile regression model, empirical results indicate that the global factors outperform the local factors. The most significant variables for all SCDS spreads are the global financial uncertainty embedded in the Chicago Board Options Exchange (CBOE) volatility index (VIX) and the global conventional bond market uncertainty embedded in the Merrill Lynch Option Volatility Estimate (MOVE) index. Moreover, the MOVE index affects the various SCDS spreads only when the CDS markets are bullish. Interestingly, the SCDS spreads are not affected by the global economic policy and the gold market uncertainties. Additionally, a weak dependence is observed between oil prices and SCDS spreads. For the country-specific factors, stock market returns are the most significant variable and impact the SCDS spreads at different market circumstances.

Rollover risk and credit spreads in the financial crisis of 2008

This paper investigates the asset pricing implications of rollover risk, i.e., the risk that firms might not be able to refinance their due liabilities. I find that firm-specific rollover risk coupled with deteriorating credit market conditions significantly increase firms' credit spreads. During the 2008–2009 financial crisis period, the one-year CDS spreads for high rollover risk firms are 32–72 basis points higher than the spreads of low rollover risk firms. Longer maturity CDS spreads show similar patterns with smaller magnitudes. During normal periods, however, CDS spreads are mostly explained by fundamental variables and rollover risk is not a significant determinant. Similar rollover risk effect is also observed in other financial markets, including corporate bond, stock, and options markets.

Network and Agent Dynamics with Evolving Protection against Systemic Risk

The dynamics of protection processes has been a fundamental challenge in systemic risk analysis. The conceptual principle and methodological techniques behind the mechanisms involved (in such dynamics) have been harder to grasp than researchers understood them to be. In this paper, we show how to construct a large variety of behaviors by applying a simple algorithm to networked agents, which could, conceivably, offer a straightforward way out of the complexity. The model starts with the probability that systemic risk spreads. Even in a very random social structure, the propagation of risk is guaranteed by an arbitrary network property of a set of elements. Despite intensive systemic risk, the potential of the absence of failure could also be driven when there has been a strong investment in protection through a heuristically evolved protection level. It is very interesting to discover that many applications are still seeking the mechanisms through which networked individuals build many of these protection processes or mechanisms based on fitness due to evolutionary drift. At the same time, this approach could be useful for researchers and those who need to use protection dynamics to guard against systemic risk under intrinsic randomness in artificial circumstances.

Corporate Bond Market Dysfunction During COVID-19 and Lessons from the Fed's Responses

Changes in the financial sector since the global financial crisis appear to have increased dramatically the demand for liquidity by holders of corporate bonds beyond the ability of the markets to provide it in stress events. The March market turmoil revealed the costs of liquidity mismatch in open-end bond mutual funds. The surprisingly large redemptions of investment-grade corporate bond funds added to stresses in both the corporate bond and Treasury markets. These conditions led to unprecedented Fed interventions, which significantly reduced risk spreads and improved market functioning, with much of the improvements occurring right after the initial announcement. The improved conditions allowed companies to issue bonds, which helped them to maintain employees and investment spending. The episode suggests several areas for further study and possible reforms.

Oil market conditions and sovereign risk in MENA oil exporters and importers

We analyze for the first time how various levels of oil returns and oil volatility changes affect sovereign risk in static and time-varying settings. Empirical analyses involve daily data from February 14, 2011 to November 23, 2018 covering a sample of MENA oil-exporters and importers. The results from a quantile-based approach show that the sovereign risk of MENA oil-exporters and importers is directionally predicted by shocks in oil prices and oil volatility, especially during the oil crash of 2014–2016. Overall, the impact of oil returns and volatility changes occur in a very short time span, that is within one day lag, and the quantile specific reactions of sovereign risk spreads are time varying. The impact of oil returns is asymmetric across quantiles. The results hold when we control for stock market returns. The findings have implications for investors in terms of portfolio and risk management. Importantly, the findings are useful to policymakers for sovereign risk management decisions, the cost of sovereign borrowing, and the market timing of debt issuance. Finally, the findings matter to bankers given that central and domestic banks hold large amounts of sovereign debt, which makes banking systems particularly exposed to their own sovereign stress.

Alternative policy options for combatting a downturn

▀ With limited scope for conventional monetary policy options, central banks and governments may need to turn to alternative approaches to combat slowing global growth and respond to economic shocks. ▀ Our analysis shows that not only do governments in advanced economies have limited room to cut rates but that doing so has proved less effective in boosting growth in recent years. This increases the need to look at alternatives, such as negative interest rates, renewed QE and fiscal stimulus. ▀ While negative interest rates have helped reduce borrowing costs in some economies, the impact on banks has been ambiguous. Also, lowering rates further into negative territory could be hard without incurring significant costs. ▀ QE in the form practised up to now is also likely to be less effective than in the past due to low yields, narrow risk spreads and high asset valuations. So, a deeper downturn might require more radical QE ‐ buying corporate bonds, bank loans and equities ‐ which comes with significant drawbacks. ▀ Some central bankers are starting to acknowledge the limits of monetary action, with the next step being to consider fiscal action as a more effective alternative ‐ as argued recently by the likes of Larry Summers. ▀ In our view, fiscal policy is likely to be especially effective in a climate of weak growth and low rates, with large multiplier effects. Advanced economies have more scope for fiscal stimulus than often recognised and could finance a large public investment programme by issuing ultra‐cheap long‐dated debt

Effects of QE on Sovereign Bond Spreads Through the Safe Asset Channel

We show that through the safe asset channel the excess liquidity created by QE can lead to higher sovereign bond spreads in the euro area. This unintended effect is most likely in stressed markets when excess liquidity spurs demand for tradeable safe assets, pushing down the interest rate of these assets, which widens risk spreads. Outcomes of a panel regression model estimated for individual euro area countries confirm that the excess liquidity created by QE had an upward effect on sovereign bond spreads. It indicates that the safe asset channel dominates the usual portfolio rebalancing channel. For monetary policy the results imply that QE is not an appropriate instrument to address country specific shocks.

Specialization and Business Cycle Co-Movement in the Euro Area

This paper explores whether similarities in production structures have been an important determinant of business cycle co-movement in the Euro Area. We constructed an index of cross-country differences in industry composition using value added data from 62 sectors. Then we tested whether this specialization index can explain several measures of cross-country output and employment co-movement within the European Monetary Union between 1999 and 2016. The results indicate that changes in real gross domestic product exhibit a stronger correlation between countries producing similar goods and services. However, the composition of output cannot explain co-movement in employment or unemployment. We checked the robustness of the results by dividing the sample period and by adding several control variables, including bilateral trade intensity and differences in country risk spreads.

Specialization and Business Cycle Co-Movement in the Euro Area

This paper explores whether similarities in production structures have been an important determinant of business cycle co-movement in the Euro Area. I construct an index of cross-country differences in industry composition using value added data from 62 sectors. Then I test whether this specialization index can explain several measures of cross-country output and employment co-movement within the European Monetary Union between 1999 and 2016. The results indicate that changes in real GDP exhibit a stronger correlation between countries producing similar goods and services. However, the composition of output cannot explain co-movement in employment or unemployment. I check the robustness of the results by dividing the sample period and by adding several control variables, including bilateral trade intensity and differences in country risk spreads.

Mandatory Auditor Involvement in Bank Supervision

We study the economic consequences of mandates that require bank auditors to report to bank regulators. Based on survey responses from the European Central Bank and all 28 national bank regulators within the European Union and a review of national banking regulations, we create a novel dataset on these mandates. Exploiting the cross-sectional and time-series variation in these mandates, we find evidence that auditor reporting to bank regulators reduces bank riskiness, as measured by counterparty risk and credit spreads. We also observe a decline in problem loans and risk-weighted assets, as well as improvements in timeliness of loan loss provisions. Additional analyses suggest that mandated auditor reporting increases the effectiveness of supervisory and monitoring efforts and improves market discipline of banks. However, mandated auditor reporting comes with costs: it reduces future lending growth, risky lending, and profitability, and increases audit fees paid by shareholders.

Investment Commonality across Insurance Companies: Fire Sale Risk and Corporate Yield Spreads

Insurance companies often follow highly correlated investment strategies. As major investors in corporate bonds, their investment commonalities subject investors to fire sale risk when regulatory restrictions prompt widespread divestment of a bond following a rating downgrade. Reflective of fire sale risk, the clustering of insurance companies in a bond has significant explanatory power for yield spreads, controlling for liquidity, credit risk, and other factors. The effect of insurer clustering on bond yield spreads is more evident for bonds held to a greater extent by capital-constrained insurance companies, those with ratings closer to National Association of Insurance Commissioners risk categories with larger capital requirements, and during the financial crisis.

Sovereign bond yield spreads and sustainability: An empirical analysis of OECD countries

Abstract We study whether and how a country's environmental, social, and governance (ESG) performance relates to its sovereign borrowing costs in international capital markets. We hypothesize that good ESG performance plays an economic role: It signals a country's commitment to sustainability and long-term orientation and is a buffer against negative shocks, leading to lower sovereign bond yield spreads. Using a sample of 20 OECD countries over the period 1996–2012, we show that countries with good ESG performance are associated with lower default risk and lower sovereign bond yield spreads. Moreover, we show that the social and governance dimensions have a significant negative association with sovereign bond yield spreads, whereas the environmental dimension does not.

Pricing Credit Risk for Mortgages: Credit Risk Spreads and Heterogeneity across Housing Markets

AbstractWe develop a Monte Carlo procedure to project MSA‐level house‐price paths from 2013 to 2023. These price paths are applied to a fixed portfolio of synthetic mortgages in order to estimate credit risk spreads (CRS) for each MSA. Like the well‐known annual percentage rate (APR)–which converts an array of fees into an all‐encompassing annual measure of costs to borrowers–the CRS is a holistic measure that encompasses both expected losses from default plus the cost of capital (or unexpected credit losses) needed to cover losses in a stress scenario. We find variation in the CRS across MSAs, with the range spanning 37 basis points. This range spans 86 basis points for those carrying first‐loss positions, such as private mortgage insurers. We conclude that, in order to accurately price credit risk, it is necessary to monitor more than borrower characteristics, but also local economic conditions.

The Spillover and Transmission of Chinese Financial Markets Risk

After the 2008 financial crisis, the whole world financial markets became more fluctuates, the same to China also. It is necessary to pay great attention to high volatility problem in Chinese market, and also the uncertainty problem, risk accumulation and spillover effect come along with it. This paper calculates stock market return and builds financial stress index to explore the risk spillover effect. Empirical results show that the Chinese financial market have higher volatility than other countries. The Chinese stock market had higher dynamic market co-movement with international financial markets after 2008 financial crisis. What’s more, this article also finds the financial risk spreads between China and US. When the US financial stress index increases, China's financial stress index experiences a larger increase. However, after the change in China's financial stress index, the US financial stress index has no obvious trend of change. So we should pay more attention to periods of Chinese financial market risk and its spillover.

Macroeconomic Risk, Investor Preferences, and Sovereign Credit Spreads

We study how shifting global macroeconomic conditions affect sovereign bond prices. Bondholders earn premia for two sources of systematic risk: exposure to low-frequency changes in the state of the economy, as captured by expected macroeconomic growth and volatility, and exposure to higher-frequency macroeconomic shocks. Our model predicts that the first source, labeled “long-run macro risk”, is the primary driver of the level and the cross-sectional variation in sovereign bond premia. We find support for this prediction using sovereign bond return data for 43 countries. A long-short portfolio based on long-run macro risk earns 8.11% per year in our sample.