xiaolin cheng

Bio: xiaolin cheng is an academic researcher from Rutgers University. The author has contributed to research in topics: Credit risk & Credit rating. The author has an hindex of 3, co-authored 3 publications receiving 88 citations.

Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads

Abstract: Using a large data set on credit default swaps, we study how default risk interacts with interest-rate risk and liquidity risk to jointly determine the term structure of credit spreads. We classify the reference companies into two broad industry sectors, two broad credit rating classes, and two liquidity groups. We develop a class of dynamic term structure models that include (i) two benchmark interest-rate factors to capture the libor and swap rates term structure, (ii) two credit-risk factors to capture the credit swap spreads of high-liquidity group of each industry and rating class, and (iii) both an additional credit-risk factor and a liquidity-risk factor to capture the difference between the high- and low-liquidity groups. Estimation shows that companies in different industry and credit rating classes have different credit-risk dynamics. Nevertheless, in all cases, credit risks exhibit intricate dynamic interactions with the interest-rate factors. Interest-rate factors both affect credit spreads simultaneously, and impact subsequent moves in the credit-risk factors. Within each industry and credit rating class, we also find that the average credit default swap spreads for the high-liquidity group are significantly higher than for the low-liquidity group. Estimation shows that the difference is driven by both credit risk and liquidity differences. The low-liquidity group has a lower default arrival rate and also a much heavier discounting induced by the liquidity risk.

Inflation, Fisher Equation, and the Term Structure of Inflation Risk Premia: Theory and Evidence from Tips

Abstract: In this paper, we study inflation risk and the term structure of inflation risk premia in the U.S. nominal interest rates through the Treasury Inflation Protection Securities (TIPS) and an analytical two-factor Cox-Ingersoll-Ross (CIR) model with correlated real rate and inflation. The analytical formula facilitates the estimation of the model parameters and improves the accuracy of the valuation of nominal rates and TIPS, and especially enables us to estimate the term structure of inflation risk premia. We use the two-factor model to evaluate the inflation-index bonds and study the relationship between the real rate and the expected inflation rate implied by the nominal Constant Maturity Treasury (CMT) rates for the period of January 1998 through December 2004. We use the Unscented Kalman Filter (UKF) to estimate the model and the inflation risk premium. The empirical evidence indicates that the expected inflation rate, as opposed to those derived from the consumer price indexes, is very stable and the inflation risk premia demonstrate a steep term structure.

The Term Structure of Credit Spreads: Theory and Evidence on Credit Default Swaps

Abstract: Using a large data set on credit default swaps, we perform a joint analysis of the term structure of interest rates, credit spreads, and liquidity premia. We select reference companies that fall into two broad industry sectors and two broad credit rating classes. Within each sector and credit rating class, we divide the companies into two liquidity groups based on the quote updating frequency. We then study how the term structures of credit default risk premia differ across industry sectors, credit rating classes, and liquidity groups. We develop a class of dynamic term structure models that include two benchmark interest-rate factors, two credit risk factors for the high-liquidity groups, and an additional default risk factor and a liquidity risk factor that capture the difference between the two liquidity groups. We link these factors to the instantaneous benchmark interest rate and credit spread via both an affine function and a quadratic function, and compare their relative performance. We estimate the models using a three-step procedure. First, we estimate the interest-rate factor dynamics and the instantaneous interest rate function using the libor and swap rates. Second, we take the interest-rate factors and estimate the default-risk dynamics and the instantaneous credit spread function using the average credit default spreads of the high-liquidity group for each industry sector and credit rating class. Third, we identify an additional credit risk factor and a liquidity risk factor using the credit default swap spreads in the low-liquidity group. At each step, we cast the models into a state-space form and estimate the model parameters using quasi-maximum likelihood method. Estimation shows that the quadratic specifications generate better and more uniform performance across the term structure of interest rates and credit spreads. Furthermore, firms in different industry and credit rating classes have different default risk dynamics. Nevertheless, in all cases, default risks exhibit intricate dynamic interactions with the interest-rate factors. Interest-rate factors both predict the default risk and have a contemporaneous impact on it. Within each industry and credit rating class, the average credit default swap spreads for the high-liquidity group are significantly higher than for the low-liquidity group. Estimation shows that the difference is driven by both default risk and liquidity difference. The low-liquidity group has a lower default arrival rate, and also a much heavier discounting due to low liquidity.

Testing Continuous-Time Models of the Spot Interest Rate

Abstract: Different continuous-time models for interest rates coexist in the literature. We test parametric models by comparing their implied parametric density to the same density estimated nonparametrically. We do not replace the continuous-time model by discrete approximations, even though the data are recorded at discrete intervals. The principal source of rejection of existing models is the strong nonlinearity of the drift. Around its mean, where the drift is essentially zero, the spot rate behaves like a random walk. The drift then mean-reverts strongly when far away from the mean. The volatility is higher when away from the mean.

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

Abstract: We derive an equilibrium asset pricing model incorporating liquidity risk, derivative assets, and short-selling due to hedging of non-traded risk. We show that, both for positive-net-supply assets and derivatives, the sign of liquidity effects depends on investor heterogeneity in non-traded risk exposure, risk aversion, horizon and wealth. We also show that liquidity risk affects derivatives in a different way than positive-net-supply assets. We estimate this model for the credit default swap market using GMM. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.

Liquidity Risk Premia in Corporate Bond Markets

Abstract: This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that corporate bond returns have signifcant exposures to fluctuations in treasury bond liquidity and equity market liquidity. Further, this liquidity risk is a priced factor for the expected returns on corporate bonds, and the associated liquidity risk premia help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.6% per annum for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1.5% per annum. We find very similar evidence for the liquidity risk exposure of corporate bonds for a sample of European corporate bond prices.

Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields †

Abstract: Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average.

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

Abstract: We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short-selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short-sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive-net-supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.