This paper analyzes the components of corporate credit spreads. The analysis is based on a structural model that can offer a framework to understand the decomposition. The paper contends that default risk may correctly represent only a small portion of corporate credit spreads. This idea stems both from empirical evidence and from the following theoretical assumptions underlying contingent claim models of default: that markets for corporate stocks and bonds are (i) perfect, (ii) complete, and (iii) trading takes place continuously. Thus, in these models there are no transaction or bankruptcy costs, no tax effects, no liquidity effects, no jump effects reflecting market incompleteness, and no market risk factors effecting the pricing of corporate stocks or bonds. The paper starts with the use of a modified version of the Black-Scholes-Merton diffusion based option approach. We estimate corporate default spreads as simply a component of corporate credit spreads using data from November 1991 to December 1998, which includes the Asian Crisis in the Fall, 1998. First we measure the difference between the observed corporate credit spreads and option based estimates of default spreads. We define this difference as the residual spread. We show that for AAA (BBB) firms only a small percentage, 5% (22%), of the credit spread can be attributed to default risk. We show that recovery risk also cannot explain this residual spread. Next, we show that state taxes on corporate bonds also cannot explain the residual. We note that the pure diffusion assumption may lead to underestimates of the default risk. In order to include jumps to default, we next estimate what combined jump-diffusion parameters would be necessary to force default spread to eliminate the residual spread. In each rating class on average firms would be required to experience annual jumps that decrease firm value by 20% and increase stock volatility by more than 100% over their observed volatility in order to eliminate the residual spread. We consider this required increase in stock volatility to be unrealistic as the sole explanation of the residual spread. So next we consider whether the unexplained component can be partly attributable to interest rates, liquidity, and market risk factors. We find the following empirical results: i) increases in liquidity as measured by changes in each firm’s trading volume significantly reduces the residual spread, but does not alter the default spread; ii) increases in stock market volatility significantly reduces the residual spread by increasing the default spread relative to the credit spread, and iii) increases in stock market returns significantly increases the residual spread by reducing the default spread relative to the credit spread. This paper concludes that credit risk and credit spreads are not primarily explained by default and recovery risk, but are mainly attributable to taxes, jumps, liquidity, and market risk factors.

https://escholarship.org/content/qt32x284q3/qt32x284q3.pdf

The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors - eScholarship

Oil price shocks, global financial markets and their connectedness

Given the palpable fear generated by the threat of COVID-19 pandemic and the bearish sentiments of stock investors, this study represents one of the first efforts towards testing the effect of COVID-19 on the stock market returns-inflation relationship. Specifically, the study investigates the stock market returns-inflation nexus by controlling for the effect of COVID-19 pandemic in Nigeria from February 27, 2020 to April 30, 2020. Using the estimation procedures based on the generalized autoregressive conditional heteroskedasticity type models (GARCH (1,1), the GJR-GARCH), and the accounting innovation tests, our results show that COVID-19 increases volatility and distorts the positive relationship between inflation and stock market returns, which tends to negate the Fisher's hypothesis. In addition, the results reveal that the negative effects of COVID-19 on the market returns and its disruption to the stock market returns-inflation relationship may not die away rapidly considering that the duration of the pandemic is unknown. Further, these findings are validated by the innovation accounting tests. Therefore, the study presents to policymakers the consequences of COVID-19 and the urgent need to strengthen the market through collaborative efforts.

https://onlinelibrary.wiley.com/doi/pdf/10.1002/pa.2289

Testing the nexus between stock market returns and inflation in Nigeria: Does the effect of COVID-19 pandemic matter?

The effect of global crises on stock market correlations: Evidence from scalar regressions via functional data analysis

Explaining Credit Spread Changes: New Evidence from Option-Adjusted Bond Indexes

Global risk aversion and emerging market return comovements

/pdf/an-empirical-examination-of-the-generalized-fisher-effect-2t32n6uyna.pdf

An empirical examination of the generalized Fisher effect using cross-sectional correlation robust tests for panel cointegration

Based on the ‘mixture of distribution’ hypothesis, this paper investigates the relationship between trading volume and conditional volatility of returns by using 12 emerging stock market indices over the period between January 2000 and August 2006. The results show that when total trading volume is included in the conditional volatility equation as a proxy for information flow, a moderate level of decline in volatility persistence was observed only for two stock markets. In four stock markets the decline in conditional volatility persistence is very small. On the other hand, for the remaining markets, total trading volume is a poor proxy for information flow. The findings are consistent with the findings of prior research, which suggest that volume may be a good proxy for stock-level analysis, but not for marketlevel analysis. Furthermore, following Wagner and Marsh (2005) and Arago and Nieto (2005) the relationship between unexpected trading volume (surprise trading volume as an alternative proxy for information flow) and conditional volatility is analyzed. The findings illustrate that for most of the markets, the relationship between surprise volume and conditional volatility is statistically significant.

Trading volume and stock market volatility: evidence from emerging stock markets

This study measures the performance of the pairs trading strategy in an emerging stock market setting, using the methodology of Gatev et al. (2006). Distance- based pairs trading methodology gives an average excess return of 5.4 % for the top 20 best pairs portfolios. Although statistically significant, these results for the self- financing portfolios lack economic significance considering transaction and short- selling costs.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2097664_code593065.pdf?abstractid=2097664&mirid=1

The Profitability of Pairs Trading in an Emerging Market Setting: Evidence from the Istanbul Stock Exchange

Recent evidence from US stock markets shows that pairs trading strategy earns positive abnormal profits. The profitable implementation of this strategy requires the existence of strong arbitrage forces to make the prices of the stocks in a pair converge soon after the position is opened. This paper argues that arbitrage forces and as a result the performance of pairs trading strategy will be weaker in emerging than developed markets.To present evidence on this claim, it examines the performance of pairs trading strategy using data from the Istanbul Stock Exchange (ISE). Characterized by the absence of option trading for its stocks and relatively high transaction costs, the ISE provides a suitable setting for examining this claim. Overall, the results give moderate support to this argument. Nonetheless, they show that relatively large positive excess returns are available around short trading periods of between one and two months. None of the potential explanations considered, namely the level of transaction costs, the systematic risk of the pairs portfolio and the existence of short term mean reversion in stock returns, can explain the positive profits for short trading periods.

Aydin Yuksel

Papers

Global risk aversion and emerging market return comovements

An empirical examination of the generalized Fisher effect using cross-sectional correlation robust tests for panel cointegration

Trading volume and stock market volatility: evidence from emerging stock markets

The Profitability of Pairs Trading in an Emerging Market Setting: Evidence from the Istanbul Stock Exchange

Pairs trading with Turkish stocks