2012

PROJECTS FUNDED IN 2012

The Determinants of Recovery Rates in the US Corporate Bond Market

Link to PDF File: The Determinants of Recovery Rates in the US Corporate Bond Market

Marti G. Subrahmanyam, New York University
Rainer Jankowitsch, Vienna University of Economics and Business
Florian Nagler, Vienna University of Economics and Business

In this research project, we will analyze the recovery rates of defaulted bonds in the US corporate bond market. Our data set has been obtained from the Trade Reporting and Compliance Engine (TRACE) database maintained by the Financial Regulatory Authority (FINRA), and will allow us to analyze the traded prices and volumes of defaulted bonds, based on a complete set of transaction data. The detailed analysis of the microstructure of trading will allow us to estimate reliable market-based recovery rates for a broad cross-section of defaulted corporate bonds. Our emphasis in this research will be on the investigation of the relation between these recovery rates and a comprehensive set of potential determinants suggested by various theoretical models, e.g., bond characteristics, firm fundamentals and indicators of overall macroeconomic conditions. In addition, we will analyze — for the first time — the effect of liquidity on the recovery rates, which is particularly interesting, due to the potential illiquidity of bonds following default.

The valuation of bonds depends critically on recovery rates in the event of bankruptcy. The need to know these rates is especially pressing for high yield bonds for which the credit quality of the issuer may be uncertain. Managers and sponsors who invest in fixed income thus should have substantial interest in this research project, in which the authors will study recovery rates to identify the factors upon which they depend.

Are Credit Ratings Still Relevant?

Link to PDF File: Are Credit Ratings Still Relevan
Sudheer Chava, Georgia Institute of Technology
Rohan Ganduri, Georgia Institute of Technology
Chayawat Ornthanalai, University of Toronto

We examine the pricing relevance of credit rating downgrades when the underlying firm has Credit Default Swap (CDS) contracts trading on its debt. Using a sample of credit rating changes from 1998 to 2007, we find that, after a CDS contract starts trading on a firm’s debt, the firm’s stock reacts significantly less to a credit rating downgrade. Firms with traded CDS also have a smaller stock and bond market reaction to a credit rating downgrade than firms without a traded CDS. Overall, we provide evidence supporting the view that investors consider CDS markets as a viable alternative to credit ratings.

Credit ratings and market prices of credit default swaps both aggregate information about the credit quality of issuers. This study will examine whether the response of stock and bond prices to credit ratings changes differs according whether CDSs on the issuer are traded or not. The results will be of interest to managers who must evaluate credit and who need to characterize various fixed income risks.

Comomentum

Link to PDF File: Comomentum:Inferring Arbitrage Capital from Return Correlations
Dong Lou, London School of Economics
Christopher Polk, London School of Economics

We propose a novel measure of the amount of arbitrage capital allocated to the momentum strategy to test whether arbitrageurs can have a destabilizing effect in the stock market. Our measure, which we dub comomentum, is the high-frequency abnormal return correlation among stocks that a typical momentum strategy would speculate on. We show that during periods of low comomentum, momentum strategies are profitable and stabilizing, reflecting an underreaction phenomenon that arbitrageurs correct. In contrast, during periods of high comomentum, these strategies become unprofitable and tend to crash, reflecting prior overreaction due to the momentum crowd pushing prices away from fundamentals.

The success of investment strategies based on relative returns analyses rather than on fundamental value analyses depend on the total quantity of money that other investors place in these strategies. Understanding the capacity of a strategy therefore is extremely important to predicting its success. This study proposes to examine the capacity of momentum strategies. Preliminary results indicate that these strategies are successful only when they are not near capacity.

Prospect Theory and the Risk-Return Tradeoff

Link to PDF File: Prospect Theory and the Risk-Return Tradeoff
Huijun Wang, University of Minnesota
Jinghua Yan, SAC Capital LLC
Jianfeng Yu, University of Minnesota

This project applies prospect theory (PT) and mental accounting (MA) to understand the cross-sectional risk-return tradeoff in the stock market. Depending on whether the marginal investor faces capital gains (losses) relative to the reference point, there could be positive (negative) relation between risk and returns. To formally test this hypothesis, we first utilize the capital-gain-overhang (CGO) to divide stocks into groups with different exposure to PT/MA effects, and then examine the risk-return relations within each group. Our preliminary results show strong support to PT/MA effects: the classical positive risk-return tradeoff holds only among stocks with prior capital gains.

Behavior aspects of investor decision-making often produce predictable return patterns. This study examines how stocks with different capital gain overhangs behave differently. The results will be of interest to managers seeking to better understand return processes and to mutual fund sponsors who wish to better understand fund flows.

The Role of Institutional Investors in Voting: Evidence from the Securities Lending Market

Link to PDF File: The Role of Institutional Investors in Voting: Evidence from the Securities Lending Market
Reena Aggarwal,Georgetown University
Pedro A. C. Saffi,University of Cambridge
Jason Sturgess, Georgetown University

We examine the role of institutional investors in influencing corporate governance through proxy voting using data from the equity lending market. We find that investors recall their shares prior to the record date to exercise their voting right. The recall is higher for firms with weaker corporate governance, weaker performance, higher institutional ownership, and when anti-takeover or compensation proposals are on the ballot. Further, recall is most pronounced for corporate control events such as proxy fights and mergers and when proxy advisory services recommend against management. Our results indicate that corporate governance is important to institutional investors and that the proxy process is an important channel for corporate governance.

Institutional managers who have lent shares that they want to vote must recall those shares. The security lending market thus can provide information about the demand to vote shares. This study examines the determinants of that demand. The results will be interesting to managers, sponsors, and corporate executives who are interested in corporate governance issues as well as to short sellers who want to maintain positions during a vote, or who want to predict how costly borrowing will be during various votes.


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