Bond Pricing

This work empirically examines six structural models of the term structure of credit risk spreads: Merton (1974), Longstaff & Schwartz (1995) (with and without stochastic interest rates), Leland & Toft (1996), Collin-Dufresne & Goldstein (2001), and a constant elasticity of variance model. The conventional approach to testing structural models has involved the use of observable data to proxy the latent capital structure process, which may introduce additional specification error. This study extends Jones, Mason & Rosenfeld (1983) and Eom, Helwege & Huang (2004) by using implicit estimation of key model parameters resulting in an improved level of model fit. Unlike prior studies, the models are fitted from the observed dynamic term structure of firm-specific credit spreads, thereby providing a pure test of model specification. The models are implemented by adapting the method of Duffee (1999) to structural credit models, thereby treating the capital structure process is truly latent,...

We introduce a specification of habit formation featuring non-separability between consumption and leisure into an otherwise standard New Keynesian model. The model can be estimated with standard Bayesian techniques and the bond pricing implications are evaluated using higher-order approximations. The model is able to reproduce a sizeable risk premium on long-term bonds and the cyclicality of fiscal policy has an impact on the bond premium that is quantitatively important. Technology, government spending, and mark-up shocks are the main drivers of the time-variation in bond premia.

This paper gives a new taxonomy of dynamic term structure models that classifies all existing TSMs as either fundamental models or preference-free single-plus, double-plus, and triple-plus models. We exemplify the new taxonomy by considering preference-free versions of some well-known fundamental short rate models. Single-plus extensions of the fundamental models are shown to be both time-homogeneous and preference-free- two characteristics which do not simultaneously hold under any existing class of TSMs. Though the analytical apparatus for pricing fixed income securities is identical under fundamental models and single-plus models, the latter models are consistent with general non-linear forms of MPRs which may also depend upon an arbitrary set of state variables, leading to better estimates of risk-neutral parameters. The preference-free double-plus and triple-plus extensions of the fundamental models are similar to the Heath, Jarrow, and Morton [1992] models, in that time-inhomo...

This paper develops an endogenous default risk model for small open economies that interact with risk averse international investors whose preferences exhibit decreasing absolute risk aversion (DARA). By incorporating risk averse investors who trade with an emerging economy, the present model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets than the standard model with risk neutral investors. The paper shows that if investors have DARA preferences, then the emerging economy's default risk, capital flows, and bond prices are a function not only of the fundamentals of the economy but also of the level of financial wealth and risk aversion of international investors. In particular, as investors become wealthier or less risk averse, the emerging economy becomes less credit constrained. As a result, the emerging economy's default risk is lower, and its bond prices and capital inflows are higher. Additionally, with risk averse i...

SPLIT RATINGS AND THE PRICING OF CREDIT RISK RICHARD CANTOR, FRANK PACKER, AND KEVIN COLE RICHARD CANTOR is a vice president at Moody's Investors Service in New York. ... KEVIN COLE is a doctoral candi-date at the University of California at Berkeley. ...

The paper analyzes the consequences of joining markets of government discount bonds between identical economies when, in each country, there exists a positive probability of the government to default. In autarky such economies of overlapping generations of consumers with capital accumulation converge to a unique positive steady state under certain conditions. When two identical economies of this type open their markets for bonds to the consumers of the other country, diversification in portfolio demand by consumers leads to the existence of a world equilibrium with a uniform bond price in every period. Under such circumstances a symmetric stationary world equilibrium with lower risk per country exists, supported by the same level of capital and income as under autarky. However, due to the interaction of dynamic spill over effects between the bond market and the domestic markets for capital investment, the symmetric steady state may become unstable and stable asymmetric steady states...

In 2004 and 2005, long-term interest rates remained remarkably low despite improving economic conditions and rising short-term interest rates, a situation that former Fed Chairman Alan Greenspan dubbed a conundrum.We document the extent and tim-ing of this conundrum using two empirical no-arbitrage macro-finance models of the term structure of interest rates. These models confirm that the recent behavior of long-term yields has been unusual that is, it cannot be explained within the framework of the models. Therefore, we consider other macroeconomic factors omitted from the models and find that some of these variables, particularly declines in long-term bond volatility, may explain a portion of the conundrum. Foreign official purchases of U.S Treasuries appear to have played little or no role.

This paper considers and provides estimates of the term structure of interest rates based on observable bond prices. The paper opens with an account of the usefulness of the so-called zero-coupon yield curve as a tool for term structure modelling. Toward this, three methods are considered ? the Canadian model, the Nelson-Siegel model and its extension in the Svensson model. The author thereupon presents n both the estimation technique and the possible model restrictions. This theoretical background is applied to an estimation of the zero-coupon yield curve estimation derived from data from the Czech coupon bond market. Because of the relatively small number of coupon bonds currently available on the Czech market, the best results are produced by the Nelson-Siegel model. The growing number of state bond issues on the market, however, should increases the relevance of the Svensson model accordingly.

This work empirically examines six structural models of the term structure of credit risk spreads: Merton (1974), Longstaff & Schwartz (1995) (with and without stochastic interest rates), Leland & Toft (1996), Collin-Dufresne & Goldstein (2001), and a constant elasticity of variance model. The conventional approach to testing structural models has involved the use of observable data to proxy the latent capital structure process, which may introduce additional specification error. This study extends Jones, Mason & Rosenfeld (1983) and Eom, Helwege & Huang (2004) by using implicit estimation of key model parameters resulting in an improved level of model fit. Unlike prior studies, the models are fitted from the observed dynamic term structure of firm-specific credit spreads, thereby providing a pure test of model specification. The models are implemented by adapting the method of Duffee (1999) to structural credit models, thereby treating the capital structure process is truly latent,...

Abstract. This paper presents a simple two-factor model of nominal term structure of interest rates, in which the log-price kernel has an autoregressive drift process and a nonlinear GARCH volatility process. With these two state-variable processes, closed-form solutions are derived for zero-coupon bond prices as well as yield to maturity for a given time to maturity. 1.

Reduced-form credit risk models are often thought to be better suited than structural models for pricing corporate bonds. The authors challenge this view. Conditioned not only on equity but on bond and dividend information also, a structural model performs well compared to previously tested reduced-form models. In the pricing of bond portfolios, model errors are to a large extent diversifiable.

In this study, we use recent historical evidence to explore one dimension of the broad relationship between market returns and mutual fund flows: the effect of short-term market returns on mutual fund flows. Research on this issue has already confirmed high correlations between ...