Krishna Ramaswamy

Does Default Risk in Coupons Affect the Valuation of Corporate Bonds?: A Contingent Claims Model

The early work of Black and Scholes, and Merton, made the connection between conventional options and corporate liabilities. The standard textbooks now employ option-pricing arguments in discussing the valuation of stocks, bonds, convertible bonds and warrants; this discussion extends to the various features (such as call and sinking-fund features) that now are appended to these issues. The technique is to recognize that the value of a particular security derives from, or is contingent on, the value of the firm and other economic variables (such as the yield curve for government securities), and then apply the same valuation procedure that one would use to value a call option on some underlying common stock.

The valuation of floating-rate instruments: Theory and evidence

Abstract A framework for valuing floating-rate notes is developed to examine the effects of (1) lags in the coupon formula, (2) special contractual features and (3) default risk. Evidence from a sample of floaters indicates they sold at significant discounts. While lags in the coupon formulas and other contractual features make these notes more variable, they do not account for the magnitude of the discounts. We conclude that the fixed default premium in the coupon formula of a typical note is inadequate to compensate for time-varying default premiums demanded by investors, who treat other corporate short-term paper as close substitutes.

Profiting from Mean-Reverting Yield Curve Trading Strategies

This article studies a set of yield curve trading strategies that are based on the view that the yield curve mean reverts to an unconditional curve. These mean-reverting trading strategies exploit deviations in the level, slope, and curvature of the yield curve from historical norms. Some mean-reverting strategies were found to have significant positive profits. Furthermore, the profitability of one of these strategies significantly outperforms, on a risk-adjusted basis, alternative strategies of an investment bond or equity index.

The Benefits of Volume-Conditional Order-Crossing

We assess the role and viability of an order-crossing or market-clearing mechanism that is automatically triggered only when a minimum number of shares can be crossed. Such a mechanism is naturally more attractive to traders who do not require much immediacy for their trades, as liquidity is cheaper in this market than in a continuous-auction market. The volume condition that we propose is crucial to the effectiveness with which this market complements the continuous-auction market in two important ways. First, when appropriately set, the volume condition endogenously adjusts the probability that market-clearing is triggered and so keeps impatient traders and highly informed traders away. Second, because market-clearing with a large volume condition reduces the effects of adverse selection in this market, patient traders are more willing to place orders in it. As we show, these effects often combine into a Pareto-dominating equilibrium when the continuous-auction market and the crossing mechanism with the right volume condition are both open.

A Recursive Parameter Estimation Technique for Term Structure Models

In this article, the authors develop a new method of estimating multi-parameter term structure models using panel data. This technique involves recursively estimating some parameters along the cross-sectional dimension and the rest of the parameters along the time series dimension until convergence is achieved. By breaking down the parameter estimation process into two simpler procedures along these dimensions, the authors are able to isolate and solve common problems plaguing other methods such as quasi-maximum likelihood estimation via the Kalman filter. As a demonstration, they apply this technique successfully to the one-factor Vasicek and two-factor Cox–Ingersoll–Ross models using Fama–Bliss Treasury data. Simulation results indicate that this technique yields reasonable and robust parameter estimates for these models.

Predicting Short-Term Eurodollar Futures

We propose and illustrate a structural model for the forward curve produced by Eurodollar futures contracts. Our model provides a three-part functional decomposition of the forward rate: a long-term, unconditional component, a maturity-specific component, and a date-specific component. The maturity-specific component captures preferred investment habitats, and the date-specific component captures shocks to expectations of future spot rates. These functional components (modeled with exponential basis functions) of the decomposition aggregate to an arbitrage-free representation of the underlying stochastic process that drives the evolution of the Eurodollar forward curve. We demonstrate the use of this approach by fitting this model to yields over the period 12/9/1981 to 1/28/2008. The estimation is accomplished by using a Kalman filter to determine the underlying representation. The estimated yield curve provides better out-of-sample predictions than the standard random walk model in forecasts over various horizons. We further show the profitability of a trading scheme that chooses futures positions based upon the anticipated forward curve.