In the setting of "affine" jump-diffusion state processes, this paper provides an analytical treatment of a class of transforms, including various Laplace and Fourier transforms as special cases, that allow an analytical treatment of a range of valuation and econometric problems. Example applications include fixed-income pricing models, with a role for intensity-based models of default,

This paper examines the joint time series of the S&P 500 index and near-the-money short-dated option prices with an arbitrage-free model, capturing both stochastic volatility and jumps. Jump-risk premia uncovered from the joint data respond quickly to market volatility, becoming more prominent during volatile markets. This form of jump-risk premia is important not only in reconciling the dynamics implied by the joint data, but also in explaining the volatility "smirks" of cross-sectional options data. Further diagnostic tests suggest a stochastic-volatility model with two factors-one strongly persistent, the other quickly mean-reverting and highly volatile.

In the setting of ‘affine’ jump‐diffusion state processes, this paper provides an analytical treatment of a class of transforms, including various Laplace and Fourier transforms as special cases, that allow an analytical treatment of a range of valuation and econometric problems. Example applications include fixed‐income pricing models, with a role for intensity‐based models of default, as well as a wide range of option‐pricing applications. An illustrative example examines the implications of stochastic volatility and jumps for option valuation. This example highlights the impact on option ‘smirks’ of the joint distribution of jumps in volatility and jumps in the underlying asset price, through both jump amplitude as well as jump timing.

How does the market value "toxic" structured-credit securities? We study the valuation of what is possibly the most toxic of all toxic assets: the equity tranche of a CDO. In theory, CDO equity should be similar in nature to bank stock since both represent residual claims on a portfolio of loans. We find that CDO equity returns are much more related to stock returns than to fixed income returns. CDO equity returns track the returns of financial stocks much more closely than any other industry. Nearly two-thirds of the variation in CDO returns can be explained by fundamentals.

This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events (λ Q ), but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with λ Q following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in λ Q are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy.THE BURGEONING MARKET FOR SOVEREIGN CREDIT DEFAULT SWAPS (CDS) contracts offers a nearly unique window for viewing investors' risk-neutral probabilities of major credit events impinging on sovereign issuers, and their risk-neutral losses of principal in the event of a restructuring or repudiation of external debts. In contrast to many "emerging market" sovereign bonds, sovereign CDS contracts are designed without complex guarantees or embedded options. Trading activity in the CDS contracts of several sovereign issuers has developed to the point that they are more liquid than many of the underlying bonds. Moreover, in contrast to the corporate CDS market, where trading has been concentrated largely in the 5-year maturity contract, CDS contracts at several maturity points between 1 and 10 years have been actively traded for several years. As such, a full term structure of CDS spreads is available for inferring default and recovery information from market data. This paper explores in depth the time-series properties of the risk-neutral mean arrival rates of credit events (λ Q ) implicit in the term structure of sovereign CDS spreads. Applying our framework to Mexico, Turkey, and Korea, three countries with different geopolitical characteristics and credit ratings, we * Pan is with the MIT Sloan School of Management and NBER. Singleton is with the Graduate 2346The Journal of Finance find that single-factor models, in which country-specific λ Q follow lognormal processes, 1 capture most of the variation in the term structures of spreads. The maximum likelihood estimates suggest that, for all three countries, there are systematic, priced risks associated with unpredictable future variation in λ Q . Moreover, the time-series of the effects of risk premiums on CDS spreads covary strongly across countries. There are several large concurrent "run-ups" in risk premiums during our sample period (March 2001 through August 2006 that have natural interpretations in terms of political, macroeconomic, and financial market developments at the time.A more formal regression analysis of the correlations between risk premiums and the CBOE U.S. VIX option volatility index (viewed as a measure of event risk), the spread between the 10-year return on U.S. BB-rated industrial corporate bonds and the 6-month U.S. Treasury bill rate (viewed as a me...

No abstract

This paper examines the illiquidity of corporate bonds and its asset-pricing implications.Using transaction-level data from 2003 through 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bidask spreads. We establish a strong link between bond illiquidity and bond prices, both in aggregate and in the cross-section. In aggregate, changes in the market level illiquidity explain a substantial part of the time variation in yield spreads of high-rated (AAA through A) bonds, over-shadowing the credit risk component. In the cross-section, the bond-level illiquidity measure explains individual bond yield spreads with large economic significance. * Bao is from Ohio State University, Fisher College of Business (bao 40@fisher.osu.edu); Pan is from MIT Sloan School of Management, CAFR and NBER (junpan@mit.edu); and Wang is from MIT Sloan School of Management, CAFR and NBER (wangj@mit.edu). The authors thank Campbell Harvey (the editor), the associate editor, two anonymous reviewers, Andrew Lo, Ananth Madhavan, Ken Singleton, Kumar Venkataraman (WFA discussant) The illiquidity of the US corporate bond market has captured the interest and attention of researchers, practitioners and policy makers alike. The fact that illiquidity is important in the pricing of corporate bonds is widely recognized, but the evidence is mostly qualitative and indirect. In particular, our understanding remains limited with respect to the relative importance of illiquidity and credit risk in determining corporate bond spreads and how their importance varies with market conditions. The financial crisis of 2008 has brought renewed interest and a sense of urgency to this topic when concerns over both illiquidity and credit risk intensified at the same time and it was not clear which one was the dominating force in driving up the corporate bond spreads.The main objective of this paper is to provide a direct assessment on the pricing impact of illiquidity in corporate bonds, at both the individual bond level and the aggregate level.Recognizing that a sensible measure of illiquidity is essential to such a task, we first use transaction-level data of corporate bonds to construct a simple and yet robust measure of illiquidity, γ, for each individual bond. Aggregating this measure of illiquidity across individual bonds, we find a substantial level of commonality. In particular, the aggregate illiquidity comoves in an important way with the aggregate market condition, including market risk as Using the aggregate γ measure for corporate bonds, we set out to examine the relative importance of illiquidity and credit risk in explaining the time variation of aggregate bond spreads. We find that illiquidity is by far the most important factor in explaining the monthly changes in the US aggregate yield spreads of high-rated bonds (AAA through A), with an R-squared ranging from 47% to 60%. Adding an aggregate CDS index as a proxy for aggregate 1 credit risk, we find that it also plays an...

We study the nature of sovereign credit risk using an extensive sample of CDS spreads for 26 developed and emerging-market countries. Sovereign credit spreads are surprisingly highly correlated, with just three principal components accounting for more than 50 percent of their variation. Sovereign credit spreads are generally more related to the U.S. stock and high-yield bond markets, global risk premia, and capital flows than they are to their own local economic measures. We find that the excess returns from investing in sovereign credit are largely compensation for bearing global risk, and that there is little or no country-specific credit risk premium. A significant amount of the variation in sovereign credit returns can be forecast using U.S. equity, volatility, and bond market risk premia.F rancis A. Longstaff UCLA