Working Paper
Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates
Bakshi, Gurdip; Madan, Dilip B.; Zhang, Frank X. (2001)
This article presents a framework for modeling defaultable debt under alternative recovery conventions (for a wide class of processes describing recovery rates and default probability). These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be utilized to invert the market expectation of recovery rates implicit in bond prices. Among potential applications, the framework can be used for pricing and hedging credit derivatives that are contingent on the default event and/or recovery levels. Empirical implementation of these models ...
Finance and Economics Discussion Series , Paper 2001-37

Working Paper
What did the credit market expect of Argentina default? Evidence from default swap data
Zhang, Frank X. (2003)
This article explores the expectations of the credit market by developing a parsimonious default swap model, which is versatile enough to disentangle default probability from the expected recovery rate, accommodate counterparty default risk, and allow flexible correlation between state variables. We implements the model to a unique sample of default swaps on Argentine sovereign debt, and found that the risk-neutral default probability was always higher than its physical counterpart, and the wedge between the two was affected by changes in the business cycle, the U.S. and Argentine credit ...
Finance and Economics Discussion Series , Paper 2003-25

Working Paper
Investigating the sources of default risk: lessons from empirically evaluating credit risk models
Bakshi, Gurdip; Madan, Dilip B.; Zhang, Frank X. (2001)
From a credit risk perspective, little is known about the distress factors -- economy-wide or firm-specific -- that are important in explaining variations in defaultable coupon yields. This paper proposes and empirically tests a family of credit risk models. Empirically, we find that firm-specific distress factors play a role (beyond treasuries) in explaining defaultable coupon bond yields. Credit risk models that take into consideration leverage and book-to-market are found to reduce out-of-sample yield fitting errors (for the majority of firms). Moreover, the empirical evidence suggests ...
Finance and Economics Discussion Series , Paper 2001-15

Working Paper
Trading activity and price volatility in the municipal bond market
Downing, Chris; Zhang, Frank X. (2002)
Utilizing a comprehensive database of transactions in municipal bonds, we investigate the volume-volatility relationship in the muni market. We find a positive relationship between the number of transactions and a bond's price volatility. In contrast to previous studies, we find a negative relationship between average deal size and price volatility. These results are found to be robust throughout the sample. Our results are inconsistent with current theoretical models of the volume-volatility relationship. These inconsistencies may arise because current models fail to account for the effects ...
Finance and Economics Discussion Series , Paper 2002-39

Working Paper
Liquidity, default, taxes and yields on municipal bonds
Zhang, Frank X.; Wu, Chunchi; Wang, Junbo (2005)
We examine the relative yields of Treasuries and municipals using a generalized model that includes liquidity as a state factor. Using a unique transaction dataset, we are able to estimate the liquidity risk of municipals and its effect on bond yields. We find that a substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributable to the liquidity premium. Controlling for the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and corporations, and these tax rate ...
Finance and Economics Discussion Series , Paper 2005-35

Working Paper
A no-arbitrage analysis of economic determinants of the credit spread term structure
Wu, Liuren; Zhang, Frank X. (2005)
This paper presents an internally consistent analysis of the economic determinants of the term structure of credit spreads across different credit rating classes and industry sectors. Our analysis proceeds in two steps. First, we extract three economic factors from 13 time series that capture three major dimensions of the economy: inflation pressure, real output growth, and financial market volatility. In the second step, we build a no-arbitrage model that links the dynamics and market prices of these fundamental sources of economic risks to the term structure of Treasury yields and corporate ...
Finance and Economics Discussion Series , Paper 2005-59