Chunsheng Zhou, Informational Asymmetry and Market Imperfections: Another Solution to the Equity Premium Puzzle, The Journal of Financial and Quantitative Analysis, Vol. 34, No. 4 (Dec., 1999), pp. 445-464

Evaluating default correlations or the probabilities of default by more than one firm is an important task in credit analysis, derivatives pricing, and risk management. However, default correlations cannot be measured directly, multiple-default modeling is technically difficult, and most existing credit models cannot be applied to analyze multiple defaults. This article develops a first-passage-time model, providing an analytical formula for calculating default correlations that is easily implemented and conveniently used for a variety of financial applications. The model also provides a theoretical justification for several empirical regularities in the credit risk literature.

Default risk analysis is important for valuing corporate bonds, swaps, and credit derivatives and plays a critical role in managing the credit risk of bank loan portfolios. This paper offers a theory to explain the observed empirical regularities on default probabilities, recovery rates, and credit spreads. It incorporates jump risk into the default process. With the jump risk, a firm can default instantaneously because of a sudden drop in its value. As a result, a credit model with the jump risk is able to match the size of credit spreads on corporate bonds and can generate various shapes of yield spread curves and marginal default rate curves, including upward-sloping, downward-sloping, flat, and hump-shaped, even if the firm is currently in a good financial standing. The model also links recovery rates to the firm value at default so that the variation in recovery rates is endogenously generated and the correlation between recovery rates and credit ratings before default reported in Altman [J. Finance 44 (1989) 909] can be justified.

The paper investigates the effect of the time-to-build technology on investment dynamics. It explains the positive autocorrelation of investment by showing that investment is serially correlated once the time-to-build technology is taken into account. The paper also shows that the time-to-build technology can explain a substantial portion of the variation in aggregate investment data. Using estimated marginal Q, the paper illustrates that investment responds asymmetrically to different levels of Q (a fact in favor of the irreversibility argument).

Our paper re-examines the profitability of relative strength or momentum trading strategies (buying past strong performers and selling past weak performers). We find that standard relative strength strategies require frequent trading in disproportionately high cost securities such that trading costs prevent profitable strategy execution. In the cross-section, we find that those stocks that generate large momentum returns are precisely those stocks with high trading costs. We conclude that the magnitude of the abnormal returns associated with these trading strategies creates an illusion of profit opportunity when, in fact, none exists.