Pierre Collin-Dufresne

The Determinants of Credit Spread Changes

Using straight industrial bonds with quoted prices, we investigate the determinants of credit spread changes. The variables that should in theory determine credit spread changes in fact have limited explanatory power. Further, the residuals from this first-pass regression are highly cross-correlated, and principal components analysis strongly suggests they are driven by a single common factor. We investigate several macro-economic and financial variables as candidate proxies for this factor. We cannot, however, find any set of variables which explain this common systematic factor. Our results suggest the corporate bond market is a segmented market driven by corporate bond specific supply/demand shocks.

Do Credit Spreads Reflect Stationary Leverage Ratios

Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean-reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low-leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative-grade debt, consistent with recent empirical findings. Copyright The American Finance Association 2001.

Pricing Swaptions within the Affine Framework

Valuation theory for the most widely used interest rate derivatives, such as swaps, bond options, and caps and floors, is highly developed. But adapting the theory for use in the field is not trivial. Several stochastic factors at least are needed to approximate the empirical term structure, with which the model must be consistent. Affine models offer a general multifactor structure with good mathematical properties. However, if the factors follow standard probability processes, Gaussian or Cox-Ingersoll-Ross square root diffusions, for instance, the probability distributions for future bond prices, swap rates, and so on, will not have common forms. Valuing interest rate derivatives typically requires burdensome numerical solution of multivariate integrals, which limits the number of stochastic factors that can be considered, as well as the accuracy with which any given solution can be computed. Collin-Dufresne and Goldstein present a new technique for pricing interest rate derivatives in a much more efficient manner. Within an affine framework, the probability density for a bond price will not normally exist in closed-form, but all of its moments will. An Edgeworth expansion using a small number of these analytic moment expressions yields an approximation to the density function that is both very accurate and extremely fast to compute. Pricing accuracy and computation speed are increased by many orders of magnitude for a single option, and little additional computation is needed to price multiple contracts with differing strikes.

A Closed Form Formula for Valuing Mortgages

We develop a closed form formula for the value of a fixed-rate residential mortgage that includes the provision that the borrower can prepay at any time with no penalty. The value of the mortgage equals the expectation, under the risk neutral probability measure, of the future cash flows. We model future cash flows by estimating an empirical model of prepayment behavior. A second change of measure leads to a closed form expression for the expectation. The closed form values explain most of the time series variation in MBS prices. The closed form formula significantly shortens the time to calculate mortgage values and durations and can be a useful tool for portfolio management and hedging.

Endogenous Dividend Dynamics and the Term Structure of Dividend Strips

Many leading asset pricing models predict that the term structures of expected returns and volatilities on dividend strips are strongly upward sloping. Yet the empirical evidence suggests otherwise. This discrepancy can be reconciled if these models replace their exogenously specified dividend dynamics with processes that are derived endogenously from capital structure policies that generate stationary leverage ratios. Under this policy, shareholders are being forced to divest (invest) when leverage is low (high), which shifts risk from long-horizon to short-horizon dividend strips. This framework also generates stock volatility that is higher than long-horizon dividend volatility, even with constant market prices of risk.

On Bounding Credit-Event Risk Premia

Reduced-form models of default that attribute a large fraction of credit spreads to compensation for credit event risk typically preclude the most plausible economic justification for such risk to be priced--namely, a ?contagious? response of the market portfolio during the credit event. When this channel is introduced within a general equilibrium framework for an economy comprised of a large number of firms, credit event risk premia have an upper bound of just a few basis points and are dwarfed by the contagion premium. We provide empirical evidence supporting the view that credit event risk premia are minuscule.

Market Structure and Transaction Costs of Index CDSs

Despite a regulatory effort to promote all-to-all trading, the post-Dodd-Frank index-CDS market remains two-tiered. Dealer-to-client trades have higher transaction costs than interdealer trades. The difference is entirely explained by the higher, largely permanent, price impact of client trades. However, transaction costs of interdealer trades vary significantly across trading protocols. Mid-market matching and workup -- both characterized by execution risk -- incur the smallest costs. Dealer-to-client trades typically execute well inside the spread quoted on the interdealer limit order book. Thus, clients who value immediacy could not improve execution with marketable interdealer orders. This may explain the endurance of the two-tiered market structure.

Liquidity Regimes and Optimal Dynamic Asset Allocation

We solve a portfolio choice problem when expected returns, volatilities and trading-costs follow a regime-switching model. The optimal policy trades towards an aim portfolio given by a weighted-average of the conditional mean-variance portfolios in all future states. The trading speed is higher in more persistent, riskier and higher-liquidity states. It can be optimal to overweight low Sharpe-ratio assets such as Treasury bonds because they remain liquid even in crisis states. We illustrate our methodology by constructing an optimal US equity market timing portfolio based on an estimated regime-switching model and on trading costs estimated using a large-order institutional trading dataset.

Informed Trading in the Stock Market and Option Price Discovery

Using a comprehensive sample of trades from Schedule 13D filings by activist investors, we show that both directional and volatility information is reflected in stock and option prices. Option prices reflect the adverse selection risk associated with the volatility component of private information rather than the directional component. We then study the role of informed trading in price discovery and find that activists choose to trade stocks and to not trade derivatives in about 98% of cases. When they use derivatives, they typically seek to increase their overall economic exposure to the stock. We find that on days when activists accumulate shares, option implied volatility decreases and volatility skew increases. We conclude that informed trading in the stock market contributes to the flow of volatility information into option prices.

How Often Should You Take Tactical Asset Allocation Decisions

About once a quarter. We compute optimal tactical asset allocation (TAA) policies over equities and bonds when both asset returns are predictable. By varying how often the weights are reset, we estimate the benefits and costs of different frequencies of TAA decisions. Tactical tilts taking advantage of predictable stock returns generate approximately twice as much value as those market-timing bond returns.