Abstract: The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. THE PURPOSE OF THIS ARTICLE is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds ~spreads!, and, in particular, to examine whether there is a risk premium in corporate bond spreads and, if so, why it exists. Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons: 1. Expected default loss—some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium—interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium—The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable. The only controversial part of the above analyses is the third point. Some authors in their analyses assume that the risk premium is zero in the corporate bond market.1

Abstract: Liquid markets generate hundreds or thousands of ticks (the minimum change in price a security can have, either up or down) every business day. Data vendors such as Reuters transmit more than 275,000 prices per day for foreign exchange spot rates alone. Thus, high-frequency data can be a fundamental object of study, as traders make decisions by observing high-frequency or tick-by-tick data. Yet most studies published in financial literature deal with low frequency, regularly spaced data. For a variety of reasons, high-frequency data are becoming a way for understanding market microstructure. This book discusses the best mathematical models and tools for dealing with such vast amounts of data. This book provides a framework for the analysis, modeling, and inference of high frequency financial time series. With particular emphasis on foreign exchange markets, as well as currency, interest rate, and bond futures markets, this unified view of high frequency time series methods investigates the price formation process and concludes by reviewing techniques for constructing systematic trading models for financial assets.

Abstract: Financial contagion is described as a wealth effect in a continuous-time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined ~numerically! as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management. DURING THE F INANCIAL PANIC ASSOCIATED with the default of the Russian government in August 1998 and the subsequent collapse of the hedge fund Long Term Capital Management, numerous hedge funds, banks, and securities firms tried simultaneously to reduce exposures to a variety of financial instruments, such as Russian bonds, Brazilian stocks, U.S. mortgages, spreads between on-therun and off-the-run government securities, and spreads between swaps and U.S. Treasuries. Although the fundamental values of these positions would appear to have little correlation, during this financial crisis, the asset prices in these markets exhibited the following common empirical pattern: 1. Financial intermediaries suffered losses as prices moved against their positions; 2. Market depth and liquidity decreased simultaneously in several markets; 3. The volatility of prices increased simultaneously in several markets; and,

Abstract: This paper uses intraday data from the interdealer government bond market to investigate the effects of scheduled macroeconomic announcements on prices, trading volume, and bid-ask spreads. We find that 17 public news releases, as measured by the surprise in the announced quantity, have a significant impact on the price of at least one of the following instruments: a three-month bill, a two-year note, a 10-year note, and a 30-year bond. These effects vary significantly according to maturity. Public news can explain a substantial fraction of price volatility in the aftermath of announcements, and the adjustment to news generally occurs within one minute after the announcement. We document significant and persistent increases in volatility and trading volume after the announcements. Bidask spreads, on the other hand, widen at the time of the announcements, but then revert to normal values after five to 15 minutes. The effects that we document have relevant implications for yield curve modeling and for the microstructure of bond markets.

Abstract: This paper provides evidence linking corporate governance mechanisms to higher bond ratings and lower bond yields Governance mechanisms can reduce default risk by mitigating agency costs and monitoring managerial performance and by reducing information asymmetry between the firm and the lenders We find firms that have greater institutional ownership and stronger outside control of the board, enjoy lower bond yields and higher ratings on their new bond issues However, concentrated institutional ownership has an adverse effect on yields and ratings These results are robust to a specification that controls for institutional ownership being influenced by bond yields

Abstract: This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy without capital. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk free bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates), the optimal volatility of inflation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce near random walk behavior in government debt and tax rates. Third, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule. Finally, an interest-rate feedback rule whereby the nominal interest rate depends on inflation and output fits well the data emanating from the Ramsey economy. However, the fitted rule is not of the Taylor type, for the implied inflation coefficient is less than one and close to zero and the output coefficient is negative.

Abstract: This paper studies optimal .scal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy without capital. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk-free bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates)the optimal volatility of in.ation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce near random walk behavior in government debt and tax rates, as in economies with real non-state-contingent debt only. Finally, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule.

Abstract: We characterize asset return linkages during periods of stress by an extremal dependence measure. Contrary to correlation analysis, this nonparametric measure is not predisposed toward the normal distribution and can allow for nonlinear relationships. Our estimates for the G-5 countries suggest that simultaneous crashes between stock markets are much more likely than between bond markets. However, for the assessment of financial system stability the widely disregarded cross-asset perspective is particularly important. For example, our data show that stock-bond contagion is approximately as frequent as flight to quality from stocks into bonds. Extreme cross-border linkages are surprisingly similar to national linkages, illustrating a potential downside to international financial integration.

Abstract: As a result of the Asian crisis, both the virtues of domestic savings and the risks of foreign savings have been emphasized in the debate on development finance. In particular, East Asia, with its enviable saving rates, it has been argued by economists such as Joe Stiglitz and Jagdish Bhagwati, does not need foreign funds for investment and growth. This paper explores the benefits of private capital inflows by reviewing the analytical arguments advanced in the literature and by building fresh empirical evidence. Par-ticular attention is given to the independent growth impact of the various broad categories of flows in the recipient emerging markets. The paper provides panel data analysis covering 44 countries over the period 1986–97; correcting for standard growth determinants, it measures the independent growth effect of foreign direct investment, portfolio equity investment, bond flows, as well as short-term and long-term bank lending. The findings suggest that developing countries should not solely rely on national savings, but rather should encourage foreign direct investment and portfolio equity inflows so as to stimulate long-term growth prospects.

Abstract: We construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring, and allows for compensation for illiquidity. Using a new and relatively efficient method, we estimate the model using Russian dollar-denominated bonds. We consider the determinants of the Russian yield spread, the yield differential across different Russian bonds, and the implications for market integration, relative liquidity, relative expected recovery rates, and implied expectations of different default scenarios.

Abstract: We consider an environment in which individuals receive income shocks that are unobservable to others and can privately store resources. We provide a simple characterization of the unique efficient allocation of consumption in cases in which the rate of return on storage is sufficiently high or, alternatively, in which the worst possible outcome is sufficiently dire. We show that, unlike in environments without unobservable storage, the symmetric efficient allocation of consumption is decentralizable through a competitive asset market in which individuals trade riskfree bonds among themselves. In this paper, we consider an environment in which individuals have random income, and can accumulate assets through a storage technology. Their income realizations and their asset position are private information. Given these informational frictions, we provide a simple characterization of the unique efficient allocation of consumption in cases in which the rate of return on storage is sufficiently high or, alternatively, in which the worst possible outcome is sufficiently dire. We show that the symmetric efficient allocation of consumption is decentralizable through a competitive asset market in which individuals trade risk-free bonds among themselves. There is a large prior literature which examines the characteristics of efficient risksharing in dynamic settings in the presence of private information.' Unlike our paper, this literature generally finds that efficient allocations do not coincide with the equilibrium allocations of any economy with a competitive bond market (see Atkeson and Lucas (1992) in particular). The key difference between our paper and these preceding ones is that the earlier literature assumes either that agents cannot accumulate resources over time, or that, if they can, this accumulation is observable. In contrast, we assume that both agents' incomes and their stored resources are private information. It is this combination of assumptions that leads to our result. Our findings are reminiscent of Allen's (1985). He considers a dynamic principalagent relationship in which the agent is risk averse and has hidden stochastic income. The

Abstract: Market discipline is an article of faith among financial economists, and the use of market discipline as a regulatory tool is gaining credibility. Effective market discipline involves two distinct components: security holders' ability to accurately assess the condition of a firm (monitoring) and their ability to cause subsequent managerial actions to reflect those assessments (influence). Substantial evidence supports the existence of market monitoring. However, the existing evidence about market influence involves relatively rare events such as management turnover. This paper seeks evidence that U.S. bank holding companies' security price changes reliably influence subsequent managerial actions. Although we identify some patterns consistent with beneficial market influences, our methodology does not provide strong evidence that stock or (especially) bond investors regularly influence managerial actions. Day-to-day market influence remains, for the moment, more a matter of faith than of empirical evidence.

Abstract: This study demonstrates that the U.S. equity premium has declined significantly during the last three decades. The study calculates the equity premium using a variation of a formula in the classic Gordon stock valuation model. The calculation includes the bond yield, the stock dividend yield, and the expected dividend growth rate, which in this formulation can change over time. The study calculates the premium for several measures of the aggregate U.S. stock portfolio and several assumptions about bond yields and stock dividends and gets basically the same result. The premium averaged about 7 percentage points during 1926 70 and only about 0.7 of a percentage point after that. This result is shown to be reasonable by demonstrating the roughly equal returns that investments in stocks and consol bonds of the same duration would have earned between 1982 and 1999, years when the equity premium is estimated to have been zero.

Abstract: 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, leverage, firm specific risk, and recovery risk, but are mainly attributable to taxes, jumps, liquidity, and market risk factors.

Abstract: This study demonstrates that the US equity premium has declined significantly during the last three decades The study calculates the equity premium using a variation of a formula in the classic Gordon stock valuation model The calculation includes the bond yield, the stock dividend yield, and the expected dividend growth rate, which in this formulation can change over time The study calculates the premium for several measures of the aggregate US stock portfolio and several assumptions about bond yields and stock dividends and gets basically the same result The premium averaged about 7 percentage points during 1926 70 and only about 07 of a percentage point after that This result is shown to be reasonable by demonstrating the roughly equal returns that investments in stocks and consol bonds of the same duration would have earned between 1982 and 1999, years when the equity premium is estimated to have been zero

Abstract: We characterize asset return linkages during periods of stress by an extremal dependence measure Contrary to correlation analysis, this non-parametric measure is not predisposed towards the normal distribution and can account for non-linear relationships Our estimates for the G-5 countries suggest that simultaneous crashes in stock markets are about two times more likely than in bond markets Moreover, stock-bond contagion is about as frequent as flight to quality from stocks into bonds Extreme cross-border linkages are surprisingly similar to national linkages, illustrating a potential downside to international financial integration

Abstract: Although accurate bond prices are difficult to come by, many have advocated that bank supervisors use subordinated debt spreads in the surveillance of large banking organizations. Our findings indicate that subordinated debt spreads are most consistent across data sources for the most liquid bonds (i.e., those of relatively large issuance size, relatively young age, issued by relatively large firms) traded in a relatively robust overall bond market. We also find a high degree of concordance in rankings of firms by their minimum spreads across bonds with especially strong agreement about which large firms are in the tails of the spread distribution at each point in time. Our time-series results further support and provide additional guidance for the use of subordinated debt spreads in supervisory monitoring, support the need for careful judgment when interpreting such spreads, highlight difficulties with currently available data sources, and motivate the need for further research.

Abstract: Recent empirical work demonstrates that fiscal institutions in American states have real effects on state government bond rates, but the causal mechanisms have not been identified We show how laws that restrict state governments' ability to carry forward a deficit improve the ability of investors to extract information from noisy signals This affects the response of bond markets to repeated deficits in states that have these laws We argue that partisan preferences for higher spending also increase risk for investors, leading to higher interest rates We provide empirical support for our hypotheses using data from 1973–1995

Abstract: As risk aversion approaches infinity, the portfolio of an investor with utility over consumption at time T is shown to converge to the portfolio consisting entirely of a bond maturing at time T. Previous work on bond allocation requires a specific model for equities, the term structure, and the investor's utility function. In contrast, the only substantive assumption required for the analysis in this paper is that markets are complete. The result, which holds regardless of the underlying investment opportunities and the utility function, formalizes the "preferred habitat" intuition of Modigliani and Sutch.

Abstract: This paper compares the impact of shocks to U.S. interest rates and emerging market bond spreads on domestic interest rates and exchange rates across several emerging market economies with different exchange rate regimes. Consistent with conventional priors, the results indicate that interest rates in Hong Kong react much more to U.S. interest rate shocks and shocks to international risk premia than interest rates in Singapore. The results are less clearcut in the comparison of Argentina and Mexico: while interest rates (and the exchange rate) in Mexico seem to react less to U.S. interest rate shocks, they react about the same to bond spread shocks, in addition to a significant impact on the exchange rate.

Abstract: We examine how a sample of publicly traded corporate bond issuers and institutional investors, namely corporate bond funds, assess the four major nationally recognized credit rating agencies and their role in capital markets. The results show that these issuers and institutional investors differ dramatically in their assessments about rating agencies. Specifically, the majority of institutional investors require, as a matter of formal policy, only one rating when they buy rated corporate bonds, but most issuers obtain two or more ratings. Issuers and institutional investors also differ in their assessments about whether ratings accurately reflect creditworthiness and whether agencies maintain timely ratings. In aggregate, the results suggest that differences between bond issuers and institutional investors reflect the different roles that rating agencies provide in the market place.

Abstract: Annuities markets around the world are small. However, they have been growing in recent years and are likely to grow further as a result of reforms in public social security systems and private pension plans, that partially replace defined benefit plans with funded defined contribution plans. When people retire they may choose, and are sometimes required, to annuitize these defined contribution savings. Therefore, it is important to learn whether or not annuities markets exist, how they operate and what kinds of market failure can be anticipated. Several papers have already analyzed US annuities markets. This paper extends that analysis by examining annuities markets in other countries. We present evidence from Canada, the UK, Switzerland, Australia, Israel, Chile and Singapore - a variety of high and middle-income countries - and replicate the results from the US. This paper focuses on analyses of the expected present discounted value (EPDV) of cash flows from the annuity, and the money's worth ratio (MWR), which is the EPDV divided by the initial premium cost. We find that, when discounting at the risk-free rate, MWR's for annuitants are surprisingly high - greater than 95% in most countries and sometimes greater than 100%. MWR's for the average population member are lower but still exceed 90% in most cases. We show that differential interest rate structures largely explain differential monthly payouts across countries, while differential mortality rates, especially projected improvement factors, help explain differences in measured MWR's, given these monthly payouts and interest rates. The high MWR's raise the question: How do insurance companies cover their costs despite these high MWR's? We hypothesize that for each annuity sale, insurance companies get a large sum of money up-front that they invest in a portfolio of corporate bonds, mortgages, and some equities, earning a rate of return that exceeds the risk-free rate by 1.3% or more per year. They turn this "risky" portfolio into a safer annuity by a variety of risk-intermediation, term-intermediation techniques. This allows them to sell a product that is nearly risk-free, while earning a "spread" that covers their costs. We present data on cost and investment returns that are consistent with this hypothesis. The limited opportunity to earn this spread may help explain why price indexed annuities in the UK charge higher loads to cover their costs and risks. For consumers who would prefer to accept this investment risk and capture this spread themselves, the appropriate discount rate is higher and the MWR is lower, helping to explain the low demand for annuities in voluntary markets.

Abstract: The recent consultative papers by the Basel Committee on Banking Supervision has raised the possibility of an explicit role for external rating agencies in the assessment of the credit risk of banks’ assets, including interbank claims. Any judgement on the merits of this proposal calls for an assessment of the information contained in credit ratings and its relationship to other publicly available information on the financial health of banks and borrowers. We assess this issue via an event study of rating change announcements by leading international rating agencies, focusing on rating changes for European banks for which data on bond and equity prices are available. We find little evidence of announcement effects on bond prices, which may reflect the lack of liquidity in bond markets in Europe during much of our sample period. For equity prices, we find strong effects of ratings changes, although some of our results may suffer from contamination by contemporaneous news events. We also test for pre-announcement and post-announcement effects, but find little evidence of either. Overall, our results suggest that ratings agencies may perform a useful role in summarizing and obtaining non-public information on banks and that monitoring of banks’ risk through bond holders appears to be relatively limited in Europe. The relatively weak monitoring by bondholders casts some doubt on the effectiveness of a subordinated debt requirement as a supervisory tool in the European context, at least until bond markets are more developed. (J.E.L.: E53, G21, G33)

Abstract: This paper argues that securities transaction taxes throw sand not in the wheels, but into the engine of financial markets where the transformation of latent demands into realized transactions takes place. The paper considers the impact of transaction taxes on financial markets in the context of four questions. How important is trading? What causes price volatility? How are prices formed? How valuable is the volume of transactions? The paper concludes that transaction taxes or such equivalents as capital controls can have negative effects on price discovery, volatility, and liquidity and lead to a reduction in the informational efficiency of markets.

Abstract: We present and analyze new monthly index series for U.K. financial assets, covering equities, bonds, bills, and inflation. The data are consistent with the CRSP/Ibbotson series for the United States. We use our indices to estimate equity and bond premia and to make international comparisons, especially with the United States, Germany, and Japan. We illustrate potential uses of the new series by investigating stock market seasonality, inflation-linked bonds, real dividend growth rates, and the small-firm effect. While some of our findings resemble U.S. results, we also report differences between U.K. and U.S. stock market behavior. Copyright 2001 by University of Chicago Press.

Abstract: We investigate the pricing performance of three convertible bond pricing models on the French convertible bond market using daily market prices. We examine a component model separating the convertible bond into a bond and option component, a method based on the Margrabe model for pricing exchange options, and a binomial-tree model with exogenous credit risk. All three models are found to deliver theoretical values for the analyzed convertible bonds that tend to be higher than the observed market prices. The prices obtained by the binomial-tree model are nearest to market prices and the mispricing is no longer statistically significant for the majority of bonds in our sample. For all models, the difference between market and model prices is greater for out-of-the money convertibles than for at- or in-the-money convertibles.