Chunsheng Zhou

The term structure of credit spreads with jump risk

Abstract 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.

Credit derivatives in banking: Useful tools for managing risk?

Abstract We model the effects on banks of the introduction of a market for credit derivatives; in particular, credit-default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the banks financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the “lemons” problem caused by banks’ superior information about the credit quality of their loans. However, we find that the introduction of a credit-derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down.

Dynamic portfolio choice and asset pricing with differential information

Abstract This paper presents a multi-asset intertemporal general equilibrium model of portfolio selection and asset pricing with differential information. A method of Sargent (1991) is used to resolve the ‘infinite regress’ problem in information extraction and to derive a rational expectations equilibrium. The model shows that rational investors trade stocks strategically according to their perceptions about economic states and provides a rationale for investors to hold less than perfectly diversified portfolios. The information distribution among investors has an important effect on stock prices, welfare, and the investment opportunities of investors. The model helps explain a number of interesting financial regularities such as imperfect portfolio diversification and home bias.

Credit Rating and Corporate Defaults

Moodys default data from 1971 through 2000 indicate that default rates have been on the rise across almost every major rating category since the early 1970s, stopping only in the early 1990s. This evidence is consistent with the widespread belief among practitioners that the credit quality of U.S. corporate debt has worsened in the recent past. The result challenges the perception that credit ratings provide reliable guidance to fixed-income investments and has important implications for risk management and credit pricing.

Time-to-Build and Investment

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).

Informational Asymmetry and Market Imperfections: Another Solution to the Equity Premium Puzzle

This paper develops an equilibrium asset pricing model to explain the equity premium puzzle and the risk-free rate puzzle by allowing for both market frictions and informational asymmetry. The paper argues that much of the high equity premium in the Mehra and Prescott (1985).sample period can be explained by informational asymmetry among investors and the inability of many investors to diversify their portfolios. With admissible relative risk aversion coefficient γ, the model matches various key statistics quite well. The paper implies that with the development of mutual funds, the equity premium should decline as has been the case since the 1950s.