This article develops a real options theory to examine the effects of exchange rate uncertainty on foreign direct investment. Firms face a choice between participating in foreign markets through exports or investing abroad to relocate production. The model predicts that the most productive firms invest abroad when exchange rate volatility is low and export otherwise, whereas the least productive firms invest abroad when volatility is high. Aggregation over heterogeneous firms produces a negative and nonlinear relation between exchange rate uncertainty and total international investment. An analysis of eighty-four developed and emerging economies over the 1996–2012 period provides empirical support for the model’s predictions.

This paper develops a two-country asset pricing model with defaultable firms and governments. This model shows that higher sovereign credit risk in a country depresses equity prices internationally and increases their volatility. The effect is strongest during adverse economic conditions and when firms are close to financial distress. A structural estimation provides evidence that sovereign default risk in Europe affects European and U.S. stock markets through the threat of an economic slowdown.

This article proposes a structural model for sovereign credit risk with endogenous sovereign debt and default policies. A maximum-likelihood estimation of the model with local stock market prices generates daily model-implied sovereign spreads. This approach explains two-thirds of the daily variation in observed sovereign spreads for emerging and European economies over the 2000–2011 period. Global factors help to further explain the time variation in sovereign credit risk. In particular, sovereign spreads in emerging markets vary with U.S. market uncertainty, whereas European spreads depend on Euro-zone bond factors.

This paper explores how sovereign credit spreads vary with the level of governance. An analysis of 74 countries over the 2001–2016 period shows that sovereign credit default swap (CDS) spreads decrease with government effectiveness, particularly in countries exhibiting severe default risk, high indebtedness, and poor economic conditions. We formulate a theoretical explanation for these findings using a structural model in which governments adjust default and debt policies based on their abilities to collect and use fiscal revenues. The theory posits that more effective governments have less incentive to default and thus benefit from narrower credit spreads, although they may choose higher indebtedness levels.

We investigate the causal impact of corporate governance on equity volatility in a quasi-natural experimental setting by exploiting the staggered passage of governance reforms in the past 25 years. Using a sample of 33,831 firms from 48 countries, we find that equity volatility drops by one-fifth following the passage of reforms that increase board independence. This effect is driven by an adjustment in fixed operating costs as managerial expropriation decreases, rather than by changes in firms’ investments, profitability, asset risk, or financing decisions. We rationalize these findings with a model in which minority shareholders are subject to sticky managerial expropriation.

We study how shifting global macroeconomic conditions affect sovereign bond prices. Bondholders earn premia for two sources of systematic risk: exposure to low-frequency changes in the state of the economy, as captured by expected macroeconomic growth and volatility, and exposure to higher-frequency macroeconomic shocks. Our model predicts that the first source, labeled long-run macro risk, is the primary driver of the level and the cross-sectional variation in sovereign bond premia. We find support for this prediction using sovereign bond return data for 43 countries over the 1994–2018 period. A long-short portfolio based on long-run macro risk earns 8.11% per year in our sample.

Given equity's convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders' risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.

We develop an asset pricing model with endogenous corporate policies that explains how inflation jointly affects real asset prices and corporate default risk. Our model includes two empirically founded nominal rigidities: fixed nominal debt coupons (sticky leverage) and sticky cash flows. These two frictions result in lower real equity prices and credit spreads when expected inflation rises. A decrease in expected inflation has opposite effects, with even larger magnitudes. In the cross-section, the model predicts that the negative impact of higher expected inflation on real equity values is stronger for low leverage firms. We find empirical support for the model’s predictions.

Persistence risk is an endogenous source of risk that arises when a rational agent learns about the length of business cycles. Persistence risk is positive during recessions and negative during expansions. This asymmetry, which solely results from learning about persistence, causes expected returns, return volatility, and the price of risk to rise during recessions. Persistence risk predicts future excess returns, particularly at 3- to 7-year horizons. Its predictability is strongest around business-cycle peaks and troughs. We confirm the model’s predictions in the data and provide evidence that persistence risk is priced in financial markets.Received October 13, 2017; editorial decision September 19, 2018 by Editor Stijn Van Nieuwerburgh.

This paper uncovers a novel component for exchange rate predictability based on the price difference between sovereign credit default swaps denominated in different currencies. This new forecasting variable – the credit-implied risk premium – captures the expected currency depreciation conditional on a severe but rare credit event. Using data for 16 Eurozone countries, we find that the credit-implied risk premium positively forecasts the dollar-euro exchange rate return at various horizons. Moreover, a currency strategy that exploits the informative content of our predictor generates substantial out-of-sample economic value against the naïve random walk benchmark.