Knowledge that Transforms

We present a prediction model to forecast corporate defaults. In a theoretical model, under incomplete information in a market with publicly traded equity, we show that our approach must outperform ratings, Altman’s Z -score, and Merton’s distance to default. We reconcile the statistical and structural approaches under a common framework; that is, our approach nests Altman’s and Merton’s approaches as special cases. Empirically, the combined approach is indeed the most powerful predictor, and the numbers of observed defaults align well with the estimated probabilities. With a new transformation method, we obtain cycle-adjusted forecasts that still outperform ratings.

We investigate whether short sellers contribute toward the informational efficiency of market prices by trading on their private information or destabilize market prices by trading on rumors and false information. We find that short-selling activities are considerably informative about future stock returns when there is a higher likelihood of private information in stocks, as measured by insider-trading activities. Short sellers also bring considerable additional information to the market that is not fully captured by contemporaneous insider trading. Overall, these results suggest that on average, short sellers bring informational efficiency to market prices rather than destabilize them.

Pursuing delinquent borrowers requires considerable effort, and creditors may lack the incentive to exert this costly effort in uncompetitive banking sectors. To examine this, we use a uniquely large data set of public and private corporate bankruptcy filings spanning a banking-sector reform that deregulated bank entry across different regions of India. We find that increased banking competition is associated with more firms seeking a stay on assets, a decline in bankruptcy duration, and a shift toward workouts rather than liquidations. The results are consistent with creditors exerting greater effort to pursue delinquent firms and resolve bankruptcies more quickly when competition increases.

There is widespread agreement that corporate debts’ recovery rates are time varying, but empirical work in this area is limited. We show that the joint information from the term structure of senior and subordinate credit default swaps can identify the level and the dynamics of recovery rates. We estimate a reduced-form no-arbitrage model on 46 firms across different industries. We find that the term structure of expected recovery rates is, on average, downward sloping. However, an inversion occurs during the 2008 crisis, suggesting the market expects higher recoveries conditional on short-term survival. The inversion is more pronounced for firms in distressed industries.

We find the financial condition of states impacts bank credit supply through their municipal bond holdings. In particular, we treat sudden political and statutory actions during the 2011 union bargaining rights debates in Wisconsin and Ohio as exogenous shocks to state solvency. We show bank valuations and municipal bond spreads adjust to the announcements, and, over longer horizons, a new lending channel linked to state solvency emerges, whereby banks supply credit as municipal bond appreciations free up capital.

Straddles on individual stocks generally earn negative and significant returns. However, average at-the-money straddles from 3 days before an earnings announcement to the announcement date yield a highly significant 3.34% return. The positive returns on straddles indicate that investors underestimate the magnitude of uncertainty around earnings announcements. We find that positive straddle returns are more pronounced for smaller firms and firms with higher volatility, higher kurtosis, more volatile past earnings surprises, and less trading volume/higher transaction costs. This suggests that when firm signals are noisy, and/or when it is costlier to trade, investors underestimate the uncertainty associated with earnings announcements.