Howard Qi

Personal Taxes, Endogenous Default, and Corporate Bond Yield Spreads

Term structure models have often been criticized for failing to explain satisfactorily the yield spread between corporate and Treasury bonds. A potential problem is that the personal tax effect is ignored in these models. In this paper, we employ a structural model to investigate the role of personal taxes on both debt and equity returns in capital structure decisions and assess their impact on corporate bond yield spreads. It is shown that personal taxes affect the firms optimal capital structure, and the tax premium explains a substantial portion of yield spreads, especially for high-grade bonds. The predictive ability of the model for yield spreads is much improved when personal tax effects are accounted for. In controlling for the liquidity effect, we obtain implied personal income tax rates closely in line with Grahams (1999) estimates.

Valuation Methodologies and Emerging Markets

Correctly applying the valuation methodologies is important. Sabal (2007), using a well-designed example, shows that various methods give identical results, and asserts that APV is more convenient for the emerging market. However, a few issues are questionable which we intend to clarify, including (1) the evidence regarding target debt ratio; (2) the relationship between the WACC/APV and the capital structure; (3) the inconsistencies in the CCF application; and (4) why using the framework by Fernández (2004) does not necessarily prove Sabals assertion. Our study and Sabals work are both integral parts in contributing to the better understanding of business valuation.

Inferring Default Correlation from Equity Return Correlation

This paper presents a new approach for estimating default correlation by linking default correlation to equity return correlation while preserving the fundamental relation between default and asset correlations in the structural framework. Our hybrid model thus overcomes a long‐standing empirical difficulty that default correlation estimation relies on the unobservable asset process. The empirical analysis shows that our hybrid model demonstrates a considerable improvement over the existing structural model of Zhou (2001) for the sample periods of 1970‐1993 and 1990‐2010. We also illustrate the difference between the two models in predicting default correlations over the period of the 2008 financial crisis.

Parallel numerical simulation of strategic bankruptcy

In this paper, we extend the strategic default bankruptcy model to predict risky premium on defaultable bonds in a more realistic economic environment. By considering interest rates, taxes and the voltality of business operations, the model becomes considerably complicated, which imposes significant challenges on the mathematical framework as well as the computation power required in simulating the stochastic process. Since it is hard to obtain a closed form analytical solution for the framework, numerical simulation is an alternative. We present a dynamic block allocation algorithm for parallel Quasi-Monte Carlo(QMC) simulation. The convergence speed of the model is also studied. Simulation results show that our model can be used to estimate risk and risk premium in financial economics.

Cost of Capital: Spot Rate or Forward Rate?

In this study, we intend to reveal some problems with the classic valuation method -- the weighted average cost of capital (WACC) method. We first address a fundamental question about WACC, that is, should WACC be interpreted as a spot rate, a forward rate or any kind of average of either of them? We show that the nature of WACC is the expected forward rate. We next demonstrate that without understanding this nature, we may misinterpret the famous MM formula and MM Proposition II, as well as develop incorrect valuation framework. Our findings provide insightful implications to academia and practitioners for the proper interpretation and implementation of the WACC method.

Cost of capital: spot or forward rate?

ABSTRACT In this study, we intend to reveal some problems with the classic valuation method – the weighted average cost of capital (WACC) method. We first address a fundamental question about WACC, that is, should WACC be interpreted as a spot rate, a forward rate or any kind of average of either of them? We show that the nature of WACC is the expected forward rate. We next demonstrate that without understanding this nature, we may misinterpret the famous MM formula and MM Proposition II, as well as develop incorrect valuation framework. Our findings provide insightful implications to academia and practitioners for the proper interpretation and implementation of the WACC method.

A Structural Approach for Predicting Default Correlation

Default correlation is a critical concept in risk management for fixed income investment, bank management, and insurance industry, working capital management, among many. We extend the Leland-Toft term structure model into a two-firm environment and predict the default correlation between two firms by directly simulating the calibrate model based on the observed equity data (1990-2010) for various ratings. Using our empirical default correlation estimation as the benchmark, our investigation sheds more light on the structural approach in predicting default correlation. The results show that our approach outperforms the previous Zhou’s model, thereby our approach is not only theoretical improvement, but also has an empirical advantage.