Gady Jacoby

The Capital Asset Pricing Model and the Liquidity Effect: A Theoretical Approach

In this paper we develop a CAPM-based model which incorporate liquidity costs. This model implies, that for markets with nontrivial liquidity costs, the measure of systematic risk is based on returns net of bid-ask spread. Another implications of our CAPM-based model is that the relationship between the expected return and the bid-ask spread is positive and convex. This results differs from Amihud and Mendelsons (1986) concave relationship, but is consistent with empirical evidence obtained by Brennan and Subrahmanyam (1996).

Default- and call-adjusted duration for corporate bonds

Abstract Call and default can potentially alter the timing and amounts of promised cashflows for callable, corporate bonds. While prior research has indicated the theoretical importance of adjusting Macaulay duration for the impacts of default and call, the question of their relative impact remains a matter of debate [The High Yield Debt Market, Dow Jones Irwin, New York, 1990, p. 18; J. Finan. 53 (1998) 2225]. We develop a theoretical analysis incorporating both default and call effects on duration and test its implications employing a previously unexplored data base of Canadian, investment grade, corporate bond indices containing an unusual provision making it possible to identify callable and noncallable indices.

A Duration Model for Defaultable Bonds

I extend recent theoretical work on duration and derive an improved model for the risk-adjusted duration of corporate bonds. My ex-ante risk-adjusted duration is the sum of the bonds Fisher-Weil duration and the duration of the potential expected delay in recovery caused by the default option. My main conclusion is that failing to adjust duration for default is costly for high-yield bonds, especially those with a shorter time to maturity. For investment-grade bonds, this cost is trivial for all maturities. 2003 The Southern Finance Association and the Southwestern Finance Association.

Measuring credit spreads: evidence from Australian Eurobonds

Recent theoretical models including the closed-form valuation model of Longstaff and Schwartz (1995) predict that credit spreads are driven by both an asset and interest rate factor. In empirical studies the credit spread may be expressed as either the difference between, or ratio of, the risky bond to a riskless bond. Using a daily sample of non-callable Australian dollar denominated Eurobonds it is found, consistent with theory, that changes in credit spreads are negatively related to both changes in the return on All Ordinaries stock Index and changes in the Government bond yield. Interestingly, the ratio measure – termed a relative credit spread – tends to be statistically more significant than the alternate measure based upon the difference – termed an actual credit spread. However, it is shown that this result is spurious and due to the way in which relative credit spreads are constructed. Noting Duffees (1998) warning against using callable bonds, the use of only non-callable Eurobonds provides a cleaner result when compared with tests conducted by Longstaff and Schwartz (1995).

Corporate Bond Pricing and the Effects of Endogenous Default and Call Options

Recent structural models for valuing callable corporate bonds show that both callability and default options have important implications for the interest-rate sensitivity of yield spreads and the bond duration. Special attention is given to the interaction between the two risks. In this article, the authors test the main implications of these models. Specifically, they examine the interest-rate elasticity of the call spread and that of the default spread, allowing for interaction between both spreads. Furthermore, they examine the impact of both risks and their interaction on the effective duration of corporate bonds. They also test theoretical predictions regarding corporate bond sensitivity to firm value. Their findings support the predictions of the theory for bonds carrying a standard fixed-price call option and those carrying the newer make-whole option.

Duration and Pricing of TIPS

We apply risk-neutral valuation to price TIPS bonds issued by the U.S. Treasury, paying close attention to an option embedded in these bonds that guaranties that bondholders are not affected by deflation. The value of this option is assumed to be trivial in the extant literature. We use a numerical simulation to show that the option value is nontrivial. We also consider the elasticity of TIPS bonds with respect to the real rate and the nominal rate and compare it to the Macaulay duration. An empirical test provides strong support for the adjustment suggested by our model for the elasticity of TIPS bonds.

Financial Distress, Political Affiliation, and Earnings Management: The Case of Politically-Affiliated Private Firms

Using a sample of politically affiliated private firms in China, we explore the relation between corporate financial distress and earnings management. We further examine the joint moderating effects of political affiliation and regional development on this relation. The findings suggest that financially distressed firms engage more in reporting small positive earnings relative to financially healthy firms. In addition, political affiliation weakens the association between financial distress and small positive earnings management. A three-way interaction analysis indicates that the moderating effect of political affiliation is influenced by regional development.

Duration and Globalization

Many foreign-bond portfolio managers use weighted average to aggregate portfolio duration. The underlying assumptions of this practice are that foreign and domestic interest rate shifts are perfectly correlated and that exchange rate changes are trivial. Prior literature does not provide an applicable solution to this challenge. The authors present an ex ante two-factor duration model that accounts for both foreign interest rate and exchange rate exposures and can be implemented using empirical estimation. The authors calibrate their model and test it out of sample for five currencies. The results show that their model significantly improves price change predictability relative to commonly used single-factor models.

A Generalized Earnings-Based Stock Valuation Model with Learning

We present a stock valuation model in an incomplete‐information environment in which the unobservable mean of earnings growth rate (MEGR) is learned and price is updated continuously. We calibrate our model to a market portfolio to empirically evaluate its performance. Of the 8.84% total risk premium we estimate, the earnings growth premium is 4.57%, the short‐rate risk contributes 3.38%, and the learning‐induced risk premium on the unknown MEGR is 0.89% (a nontrivial 10% of the total risk premium). This result highlights the significant learning effect on valuation, implying an additional risk premium in an incomplete‐information environment.