Senay Agca

Sovereign debt and corporate borrowing costs in emerging markets

We document that the corporate sector faces higher borrowing costs when the external debt of the public sector is higher. By contrast, no significant relationship is found between domestic public debt and corporate borrowing costs. An increase in sovereign debt by one standard deviation from its sample mean is associated with 9% higher loan yield spreads. The correlation is considerably higher in countries with weak creditor rights and past sovereign default episodes. Overall, these findings suggest substantial adverse linkages between public external debt and private financing costs.

Financial Reforms, Financial Openness, and Corporate Borrowing; International Evidence

We study how credit market deregulation and increased international financial openness have changed corporate borrowing. The evidence comes from a large panel of publicly traded firms in 38 countries over the period 1994-2002. Reforms are measured with a comprehensive new index that tracks six separate dimensions. We find that these transformations have increased leverage and lengthened debt maturity in advanced economies, as expected, suggesting that in these countries corporate credit markets have become deeper. In emerging economies, the picture is more mixed: more international openness has led to more leverage but shorter debt maturity. Financial sector reforms have reduced leverage, while their effects on debt maturity have differed depending on the type of reform. Importantly, the differential impact of openness and reforms on the leverage and debt maturity of firms in advanced and emerging market countries also emerges when we distinguish between firms that are potentially financially constrained and firms that are not. These findings suggest that in emerging economies fundamental institutional weaknesses make it difficult to secure the benefits of international financial openness and domestic financial reforms.

Speed and accuracy comparison of bivariate normal distribution approximations for option pricing

variate normal probability. We compare the performance of five analytical approximation methods for bivariate normal probabilities used in the computation of compound and min–max options against an externally tested benchmark of Simpson numerical integration. Each of the methods is very accurate with all probability errors less than 10–6 and the average probability error less than 10–7. The maximum error in an option price calculation is US

Implied Correlations: Smiles or Smirks?

0.01, the average error is less than 2.0 × 10–4, and an error of as large as US

The Performance of Alternative Interest Rate Risk Measures and Immunization Strategies under a Heath-Jarrow-Morton Framework

0.01 is rare. The Divgi method is the most accurate method for compound options, and the Owen method is the most accurate for min–max options. The Drezner–Wesolowsky method performs well in terms of accuracy and best in terms of speed. No single method emerges as the best overall, though the more widely cited Drezner method is consistently the least accurate, as well as the second slowest method.

Banking Sector Reforms and Corporate Borrowing Costs in Emerging Markets

Developing a pricing model for CDOs that can actually be implemented is a very challenging problem. In a credit portfolio with N obligors, there are N individual default probabilities, (N2 - N)/2 correlations, and N recovery rates, all of which are important determinants of the portfolio loss distribution. Fitting the default probabilities alone typically requires specifying probability distributions for the shared and idiosyncratic underlying factors. In light of all this complexity, the Gaussian copula model applied to a homogeneous portfolio has become the industry standard approach. But the shortcomings of this model in explaining market prices for CDO tranches are very visible in the strange, but consistent, v-shaped implied correlation skew. Agca, Agrawal, and Islam consider the many simplifying assumptions of the Gaussian copula model and explore the importance of each by weakening one at a time and studying how the correlation skew changes. Does allowing the common factor or the idiosyncratic factors to come from a fat-tailed distribution, rather than the normal, make a big difference? For the shared factor, yes, but for the idiosyncratic factor, no. How important is the assumption that all correlations are equal versus being distributed over a wide range as is the case when the correlations are estimated from the data? Neither seems to make much difference to the implied correlation skew. In the end, we learn which assumptions make the most difference in CDO pricing—even though the true source of the correlation skew remains elusive.

Can CDO Equity Be Short on Correlation

Using a Monte Carlo simulation, this study addresses the question of how traditional risk measures and immunization strategies perform when the term structure evolves in a Heath-Jarrow-Morton (1992) manner. The results suggest that, for immunization purposes, immunization strategies and portfolio formation strategies are more important than interest rate risk measures. The performance of immunization strategies depends more on the transaction costs and the holding period than on the risk measures. Moreover, the immunization performance of bullet and barbell portfolios is not very sensitive to interest rate risk measures.

Fiscal Consolidation and the Cost of Credit; Evidence from Syndicated Loans

Using a panel data set of syndicated bank loans in emerging markets, we find that banking sector reforms that improve bank competition and facilitate bank privatization lead to lower borrowing costs, suggesting that these reforms improve efficiency in credit markets. Reforms that tighten bank supervision, however, increase loan spreads, consistent with better risk pricing with effective oversight. Bank competition and supervision reforms affect borrowing costs primarily in countries with low corruption and well-functioning legal environment. Bank privatization reforms are effective in countries with better investment profiles. These results suggest that the success of banking reforms depend closely on the quality of institutions.

Financial Integration and Corporate Cash Holdings

Collateralized debt obligations (CDO) became very popular investment vehicles in recent years—until the financial crisis started unfolding in summer 2007. As evidenced by the recent crisis, there was a failure by market participants to understand the complex relationships between various risk drivers, such as correlations and their impact on the credit worthiness of different tranches across a CDO capital structure. As a step in the direction of understanding these risks, this article examines the impact of correlation on the value of a CDO equity tranche. By examining the impact of an increase in correlation among underlying assets on the value of a collateralized debt obligation (CDO) equity tranche, the authors show that, contrary to general perception, CDO equity can be short on correlation. Specifically, when the underlying reference portfolio comprises high quality assets (assets with low probability of default) or diverse assets (assets with low correlations), the upfront price of a CDO equity tranche can increase with correlation. The implication of these findings is that not all senior and equity tranche trade combinations provide effective correlation hedging. In fact, in some cases, this type of “hedge” might actually increase the correlation risk.

Two extensions for fitting discrete time term structure models with normally distributed factors

We examine how the cost of corporate credit varies around fiscal consolidations aimed at reducing government debt. Using a new dataset on fiscal consolidations and syndicated corporate loan data, we find that loan spreads increase with fiscal consolidations, especially for small firms, domestic firms, and for firms with limited alternative financing sources. These adverse effects are mitigated substantially if consolidations are large, and can be avoided if consolidations are also accompanied with more adaptable macroeconomic policies and implemented by a stable government. These findings suggest that lenders price the short-term recessionary effects in loans but large consolidations can reduce or undo the increase in spreads, especially under favorable country conditions, by signaling credibility and creating expansionary expectations.