We show that the effect of regulation on credit rating informativeness depends on asset complexity. Using the Dodd-Frank Act as a shock to the rating industry, we analyze the impact of rating changes on market prices, conditioning on various measures of complexity. Rating informativeness improves after Dodd-Frank, but not for assets with high complexity. Our results are robust to alternative measures of informativeness and provide strong evidence that the impact of regulation varies in the cross-section of securities. Our findings are consistent with models combining rating shopping with rating agencies that strategically decide on information acquisition and rating inflation.

The recent credit crisis has highlighted the importance of market liquidity and its interaction with the price of credit risk. We investigate this interaction by relating the liquidity of corporate bonds to the basis between the credit default swap (CDS) spread of the issuer and the par-equivalent bond yield spread. The liquidity of a bond is measured using a recently developed measure called latent liquidity , which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts after controlling for other realized measures of liquidity. Analysis of interaction effects shows that highly illiquid bonds of firms with a greater degree of uncertainty are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of “shorting” illiquid bonds. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm- and bond-level variables related to credit risk affect the basis, indicating that the CDS spread does not fully capture the credit risk of the bond.

We propose a multifactor model in which the spot rate, LIBOR, follows a lognormal process, with a stochastic conditional mean, under the risk-neutral measure. In addition to the spot rate factor, the second factor is related to the premium of the first futures rate over the spot LIBOR. Similarly, the third factor is related to the premium of the second futures rate over the first futures rate. We calibrate the model to the initial term structure of futures rates and to the implied volatilities of interest rate caplets. We then apply the model to price interest rate derivatives such as European- and Bermudan-style swaptions, and yieldspread options. The model can be employed to price more complex interest rate derivatives such as path-dependent derivatives or multi-currency-dependent derivatives because of its Markovian property.

In this article, we suggest an efficient method of approximating a general, multivariate log-normal distribution by a multivariate binomial process. There are two important features of such multivariate distributions. First, the state variables may have volatilities that change over time. Second, the two or more relevant state variables involved may covary with each other in a specified manner, with a time-varying covariance structure. We discuss the asymptotic properties of the resulting processes and show how the methodology can be used to value a complex, multiple exercisable option whose payoff depends on the prices of two assets. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Sovereign Debt Management Office of the Kingdom of Denmark decided in 2017 to pay direct compensation to certain financial intermediaries for providing liquidity in its sovereign bond market. We analyze the extent to which market liquidity and liquidity premia in the Danish sovereign bond market changed in response to this new market design and, in particular, the compensation offered to liquidity providers. We also investigate whether the new compensation scheme for market makers is cost-efficient for the Kingdom of Denmark through lower bond liquidity premia, bond yields and debt service costs. We find that improvements in market liquidity conditions lead to potential savings, net of costs, for the Kingdom of Denmark of DKK 23.12 million over the lifetime of the bonds issued every year as a direct benefit, and to a decrease in interest expenses for the real economy of about 0.07% of nominal GDP as one indirect benefit. From these findings, we derive policy recommendations for the Kingdom of Denmark, as well as other European countries that currently generally employ an indirect rather than a direct compensation scheme.

This paper investigates the liquidity effect in asset pricing by studying the liquidity–premium relationship of an American depositary receipt (ADR) and its underlying share. Using the [Amihud, Yakov, 2002. Illiquidity and stock returns: cross-section and time series effects. Journal of Financial Markets 5, 31–56] measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity and lower home share liquidity, in terms of changes in these variables. We find that the liquidity effects remain strong after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the stock market performance, as well as several variables measuring the openness and transparency of the home market.

We value American options on bonds using a generalization of the Geske–Johnson (Geske, R., Johnson, H., 1984. Journal of Finance 39, 1151–1542) (GJ) technique. The method requires the valuation of European options, and options with multiple exercise dates. It is shown that a risk-neutral valuation relationship (RNVR) along the lines of Black–Scholes (Black, F., Scholes, M., 1973. Journal of Political Economy 81, 637–659) model holds for options exercisable on multiple dates, even under stochastic interest rates, when the price of the underlying asset is lognormally distributed. The proposed computational procedure uses the maximized value of these options, where the maximization is over all possible exercise dates. The value of the American option is then computed by Richardson extrapolation. The volatility of the underlying default-free bond is modeled using a two-factor model, with a short-term and a long-term interest rate factor. We report the results of simulations of American option values using our method and show how they vary with the key parameter inputs, such as the maturity of the bond, its volatility, and the option strike price.

This paper investigates how individual attention triggers influence financial risk-taking based on a large sample of trading records from a brokerage service that sends standardized push messages on stocks to retail investors. By exploiting the data in a difference-in-differences (DID) setting, we find attention triggers increase investors’ risk-taking. Our DID coefficient implies attention trades carry, on average, a 19 percentage-point-higher leverage than non-attention trades. We provide a battery of cross-sectional analyses to identify the groups of investors and stocks for which this effect is stronger.

We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity effects are more pronounced in periods of financial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and find that liquidity effects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is significantly larger in periods of crisis, and for speculative grade bonds.