Yan Alice Xie

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.

Effects of Sovereign Risk on Duration: Evidence from European and Latin American Sovereign Bond Markets

We examine effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996-2011. We compare the sovereign risk-adjusted duration for U.S. dollar-denominated sovereign bonds with their Macaulay duration for both investment- and speculative-grade bonds. We find that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all bonds, regardless of the bond rating and maturity. Further, the “shortening” effect of sovereign risk on duration is generally stronger among bonds of lower ratings. During the recent global financial crisis, the “shortening” effect was dampened for quality sovereign bonds. But the sovereign risk effect on duration was intensified for BBB and BB rated bonds, reflecting investors’ perception of increasing likelihood of default by issuing nations. Results are robust when CDS prices are used as a proxy for changes in sovereign risk. Moreover, the regional analysis shows that sovereign risk shortens duration much less for sovereign bonds issued by the EU and Latin American countries than for non-EU member counterparts. Our study demonstrates the importance of, and provides a practical guide for, bond portfolio managers to account for sovereign risk in managing interest rate risk exposure in their investments.

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.

Managing risk in sovereign bond portfolios: The impact of sovereign and call risks on duration

Abstract The study examines the joint effect of sovereign and call risks on the duration of callable sovereign bonds over the period 1996–2011. The results indicate that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for U.S. dollar-denominated investment-grade callable sovereign bonds. Further, the “shortening” effect of sovereign and call risks on duration is generally stronger among bonds of lower ratings. Similar results are obtained when CDS prices are used as a proxy for changes in sovereign risk. Results from this study emphasize the importance of considering the joint effect of sovereign and call risks in managing the interest rate risk exposure in fixed income investments.

Sovereign risk and its changing effects on bond duration during financial crisis

We examined the effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996 to 2011. We compared the sovereign risk-adjusted duration with the Macaulay duration for both investment- and speculative-grade US dollar-denominated sovereign bonds. We found that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all ratings, and the ‘shortening’ effect is stronger for lower rated bonds, which generally intensified during the recent financial crisis. Results are robust when credit default swap (CDS) prices are used as a proxy for changes in sovereign risk. This study provides evidence for advocating the importance of adjusting the bond duration for sovereign risk. More important, this study provides a practical methodology for estimating a sovereign risk-adjusted duration measure for managing international bond portfolios.

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.