Desislava Vladimirova, Dirk Schiereck, Maximilian Stroh
Emerging market corporate bonds are perceived to offer attractive diversification potential and risk-adjusted returns, but to be illiquid. This study expands the empirical evidence by examining the liquidity of emerging market debt by solving a triangular structured system. We find emerging market bond liquidity both to share common determinants with developed markets and be influenced by macroeconomic factors. As the overall level of liquidity is lower than in developed markets, we propose a liquidity estimation model, which allows systematic factor investors to decrease the share of illiquid assets in their portfolio by roughly 3 percentage points and 10 percentage points during the COVID-19 pandemic.
{"title":"Managing Liquidity of Emerging Markets Corporate Debt","authors":"Desislava Vladimirova, Dirk Schiereck, Maximilian Stroh","doi":"10.3905/jfi.2023.1.159","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.159","url":null,"abstract":"Emerging market corporate bonds are perceived to offer attractive diversification potential and risk-adjusted returns, but to be illiquid. This study expands the empirical evidence by examining the liquidity of emerging market debt by solving a triangular structured system. We find emerging market bond liquidity both to share common determinants with developed markets and be influenced by macroeconomic factors. As the overall level of liquidity is lower than in developed markets, we propose a liquidity estimation model, which allows systematic factor investors to decrease the share of illiquid assets in their portfolio by roughly 3 percentage points and 10 percentage points during the COVID-19 pandemic.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"220 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2023-03-21","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"135001251","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Securitization has been a subject of interest in the security design literature, and various models have been developed to explain the existence of senior securities and junior securities. However, securitization structures are far more complex than a simple tranching by seniority, and they manipulate interest as well as principal. The authors first address the fundamental reasons why some investors require par-priced securities, before modeling the contractibility of both interest and principal, as well as the par-pricing constraint. The authors can derive optimal designs closely resembling actual securitization structures. The authors also analyze the interactions between collateral characteristics and pricing at equilibrium, and show how much more attractive an excess-spread structure is relative to a more standard structure as expected collateral losses increase, explaining the widespread use of these mechanisms on low-quality collateral. The authors ascribe the fact that financial economics have not sought to explain the peculiar nature of structural complexity to an epistemological framework that privileged consistency with corporate debt analysis.
{"title":"Explaining Complexity in Actual Securitization Structures: An Epistemic Pitfall in Corporate Finance","authors":"L. Gauthier","doi":"10.3905/jfi.2023.1.158","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.158","url":null,"abstract":"Securitization has been a subject of interest in the security design literature, and various models have been developed to explain the existence of senior securities and junior securities. However, securitization structures are far more complex than a simple tranching by seniority, and they manipulate interest as well as principal. The authors first address the fundamental reasons why some investors require par-priced securities, before modeling the contractibility of both interest and principal, as well as the par-pricing constraint. The authors can derive optimal designs closely resembling actual securitization structures. The authors also analyze the interactions between collateral characteristics and pricing at equilibrium, and show how much more attractive an excess-spread structure is relative to a more standard structure as expected collateral losses increase, explaining the widespread use of these mechanisms on low-quality collateral. The authors ascribe the fact that financial economics have not sought to explain the peculiar nature of structural complexity to an epistemological framework that privileged consistency with corporate debt analysis.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"33 1","pages":"88 - 104"},"PeriodicalIF":0.0,"publicationDate":"2023-03-02","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"47698709","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
The purpose of this article is to illustrate the use of reduced-form credit risk models for valuing defaultable coupon-bearing securities, such as risky sovereign bonds, corporate bonds, and retail loans like auto loans and mortgage loans. The authors focus on issues in the application of these models and not the mathematical derivations of the formulas employed.
{"title":"A Practical Guide to the Valuation of Coupon-Bearing Fixed Income Securities","authors":"R. Jarrow, Donald R. van Deventer","doi":"10.3905/jfi.2023.1.157","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.157","url":null,"abstract":"The purpose of this article is to illustrate the use of reduced-form credit risk models for valuing defaultable coupon-bearing securities, such as risky sovereign bonds, corporate bonds, and retail loans like auto loans and mortgage loans. The authors focus on issues in the application of these models and not the mathematical derivations of the formulas employed.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"33 1","pages":"80 - 87"},"PeriodicalIF":0.0,"publicationDate":"2023-02-27","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"41335441","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We employ the state-of-the-art resampling procedure designed by Crump and Gospodinov (2019) to assess the predictive ability of the benchmark Cochrane-Piazzesi return-predicting factor in four important Treasury markets. We find that i) it accounts for excess returns better than the slope; ii) it has a better economic performance than the slope factor and the unconditional “long-always” strategy; iii) its outperformance is not due to overfitting; and iv) it retains its greater predictive abilities out of sample.
{"title":"Does the Cochrane-Piazzesi Factor Predict? An International Resampling Perspective","authors":"R. Rebonato, Pietro Zanetti","doi":"10.3905/jfi.2023.1.156","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.156","url":null,"abstract":"We employ the state-of-the-art resampling procedure designed by Crump and Gospodinov (2019) to assess the predictive ability of the benchmark Cochrane-Piazzesi return-predicting factor in four important Treasury markets. We find that i) it accounts for excess returns better than the slope; ii) it has a better economic performance than the slope factor and the unconditional “long-always” strategy; iii) its outperformance is not due to overfitting; and iv) it retains its greater predictive abilities out of sample.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"60 - 75"},"PeriodicalIF":0.0,"publicationDate":"2023-02-02","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"49196153","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Based on the Chen, Hsieh, and Huang (2017) interest rate model, this research explores the analytical approach for pricing CMS spread options. We first derive a complex joint density for two swap rates composed of sequential forward rates and approximate the joint density by bivariate normals. After applying the methods of Pearson (1995) and Li, Deng, and Zhou (2008), we obtain two analytical pricing models and examine their accuracy using numerical analysis. Finally, we empirically show the predictive power of the implied volatility of CMS options for future economic states.
{"title":"CMS Spread Options Pricing under the CHH Model","authors":"Ren‐Raw Chen, Xiaowei Li, Pei-lin Hsieh","doi":"10.3905/jfi.2023.1.155","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.155","url":null,"abstract":"Based on the Chen, Hsieh, and Huang (2017) interest rate model, this research explores the analytical approach for pricing CMS spread options. We first derive a complex joint density for two swap rates composed of sequential forward rates and approximate the joint density by bivariate normals. After applying the methods of Pearson (1995) and Li, Deng, and Zhou (2008), we obtain two analytical pricing models and examine their accuracy using numerical analysis. Finally, we empirically show the predictive power of the implied volatility of CMS options for future economic states.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"83 - 107"},"PeriodicalIF":0.0,"publicationDate":"2023-02-02","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"49620590","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This article examines the ability of bond investors to detect and adjust for potentially biased credit ratings. It finds evidence that investors require higher yield spreads on bonds with upwardly biased ratings, and that unusual yield spreads have predictive power for rating changes and defaults within 3 years of bond issuance. Bonds with unusually high yield spreads are more (less) likely to be downgraded (upgraded). Furthermore, 3-year default rates for those bonds are 2.5 times those of bonds with unusually low yield spreads. These findings suggest that yield spread could be a better measure of credit risk than ratings.
{"title":"Do Bond Investors Know Better than the Credit Rating Agencies?","authors":"M. Livingston, Yao Zheng, Lei Zhou","doi":"10.3905/jfi.2023.1.154","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.154","url":null,"abstract":"This article examines the ability of bond investors to detect and adjust for potentially biased credit ratings. It finds evidence that investors require higher yield spreads on bonds with upwardly biased ratings, and that unusual yield spreads have predictive power for rating changes and defaults within 3 years of bond issuance. Bonds with unusually high yield spreads are more (less) likely to be downgraded (upgraded). Furthermore, 3-year default rates for those bonds are 2.5 times those of bonds with unusually low yield spreads. These findings suggest that yield spread could be a better measure of credit risk than ratings.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"20 - 43"},"PeriodicalIF":0.0,"publicationDate":"2023-01-20","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"49041713","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
In this article, we review the transition from interbank offered rates (IBORs) to the new risk-free rates (RFRs) introduced as a result of the process for determining IBOR being discontinued. Focusing on the quantitative aspects of the transition, we describe the differences between the forward-looking rates used under the IBOR environment (both single- and dual-curve IBOR environments) and the backward-looking rates used under the RFR one. Furthermore, we analyze the pricing models for interest rate derivatives across such different frameworks: the single-curve IBOR rates environment (in force before the 2007–2009 credit crisis), the dual-curve IBOR rates environment (in force after the 2007–2009 credit crisis), and the new RFR environment (officially introduced starting January 1, 2022). In particular, we describe the evolution of pricing models for the most relevant plain-vanilla interest-rate derivatives: interest rate swaps, overnight indexed swaps, caplets/floorlets, and swaptions.
{"title":"The Transition from Interbank Offered Rates to Risk-Free Rates: Evolution in Pricing Models for Interest Rate Derivatives","authors":"Vincenzo Russo, Frank J. Fabozzi","doi":"10.3905/jfi.2023.1.153","DOIUrl":"https://doi.org/10.3905/jfi.2023.1.153","url":null,"abstract":"In this article, we review the transition from interbank offered rates (IBORs) to the new risk-free rates (RFRs) introduced as a result of the process for determining IBOR being discontinued. Focusing on the quantitative aspects of the transition, we describe the differences between the forward-looking rates used under the IBOR environment (both single- and dual-curve IBOR environments) and the backward-looking rates used under the RFR one. Furthermore, we analyze the pricing models for interest rate derivatives across such different frameworks: the single-curve IBOR rates environment (in force before the 2007–2009 credit crisis), the dual-curve IBOR rates environment (in force after the 2007–2009 credit crisis), and the new RFR environment (officially introduced starting January 1, 2022). In particular, we describe the evolution of pricing models for the most relevant plain-vanilla interest-rate derivatives: interest rate swaps, overnight indexed swaps, caplets/floorlets, and swaptions.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"45 - 59"},"PeriodicalIF":0.0,"publicationDate":"2023-01-04","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"46305226","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Pub Date : 2022-12-31DOI: 10.3905/jfi.2022.32.3.049
Boyu Wu, Amina Enkhbold, Asawari Sathe, Qian Wang
The Federal funds rate is a cornerstone of asset pricing that has a significant impact on asset valuation and portfolio performance. However, estimating it reliably can be a challenging issue given that the FOMC makes monetary policy decisions based on complex economic conditions. The authors leveraged existing literatures’ findings on factors and combined those major factor categories into the new model, which includes inflation, labor markets, financial condition, and proxy of global market, and the authors selected the optimal data series to optimize the effectiveness of detecting Fed decisions through a classification factor selection process. Also, the authors improved the regression from fixed coefficients to gradient boosting nonlinear regression approach to reflect the dynamic interconnections among all the factors and their lags through different periods. Upon conducting out-of-sample forecasting, with these selected factors and machine learning gradient boosting regression, the out-of-sample RMSE improved by 77% from traditional Taylor rule model, which offered an alternative robust solution for forecasting the Federal fund rates that can be further applied to asset pricing and investing.
{"title":"How Does the Fed Make Decisions: A Machine Learning Augmented Taylor Rule","authors":"Boyu Wu, Amina Enkhbold, Asawari Sathe, Qian Wang","doi":"10.3905/jfi.2022.32.3.049","DOIUrl":"https://doi.org/10.3905/jfi.2022.32.3.049","url":null,"abstract":"The Federal funds rate is a cornerstone of asset pricing that has a significant impact on asset valuation and portfolio performance. However, estimating it reliably can be a challenging issue given that the FOMC makes monetary policy decisions based on complex economic conditions. The authors leveraged existing literatures’ findings on factors and combined those major factor categories into the new model, which includes inflation, labor markets, financial condition, and proxy of global market, and the authors selected the optimal data series to optimize the effectiveness of detecting Fed decisions through a classification factor selection process. Also, the authors improved the regression from fixed coefficients to gradient boosting nonlinear regression approach to reflect the dynamic interconnections among all the factors and their lags through different periods. Upon conducting out-of-sample forecasting, with these selected factors and machine learning gradient boosting regression, the out-of-sample RMSE improved by 77% from traditional Taylor rule model, which offered an alternative robust solution for forecasting the Federal fund rates that can be further applied to asset pricing and investing.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"49 - 60"},"PeriodicalIF":0.0,"publicationDate":"2022-12-31","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"46471631","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Pub Date : 2022-12-31DOI: 10.3905/jfi.2022.32.3.001
Stanley J. Kon
{"title":"Editor’s Letter","authors":"Stanley J. Kon","doi":"10.3905/jfi.2022.32.3.001","DOIUrl":"https://doi.org/10.3905/jfi.2022.32.3.001","url":null,"abstract":"","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"1"},"PeriodicalIF":0.0,"publicationDate":"2022-12-31","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"45066095","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Virtually every longer-term tax-exempt municipal bond is callable, usually at par 10 years after issuance. Borrowers pay for the call option with an above-market coupon or by accepting a lower sale price. We explore how the value of the option compares to its cost. Is a fairly priced call option a good deal for the municipality? The remarkable finding is that the call option is undesirable, because its cost exceeds its expected benefit. Instead of issuing callable bonds at lower prices or with higher coupons, municipal borrowers should issue optionless bonds.
{"title":"Callable Tax-Exempt Bonds Are Too Costly","authors":"A. Kalotay","doi":"10.3905/jfi.2022.1.152","DOIUrl":"https://doi.org/10.3905/jfi.2022.1.152","url":null,"abstract":"Virtually every longer-term tax-exempt municipal bond is callable, usually at par 10 years after issuance. Borrowers pay for the call option with an above-market coupon or by accepting a lower sale price. We explore how the value of the option compares to its cost. Is a fairly priced call option a good deal for the municipality? The remarkable finding is that the call option is undesirable, because its cost exceeds its expected benefit. Instead of issuing callable bonds at lower prices or with higher coupons, municipal borrowers should issue optionless bonds.","PeriodicalId":53711,"journal":{"name":"Journal of Fixed Income","volume":"32 1","pages":"77 - 82"},"PeriodicalIF":0.0,"publicationDate":"2022-12-22","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"46041177","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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