Essays on credit risk models and implied volatility biases

Abstract

This thesis is comprised of three parts. The first part develops a theoretical framework for valuation of debt and equity considering the liquidation rights of creditors and examines the effects of transfer of control rights. Creditors’ liquidation decisions are modeled and a numerical method for assessment of equity and debt values is developed. In addition, this model supports arguments that ex-ante efficiency of bankruptcy procedures can be achieved by transferring control rights from equityholders to debtholders upon bankruptcy of a firm. In the second part, the global spread of credit crunches and transmission of unexpected shocks across regions and firms are analyzed. Contagion effects in corporate credit default swap markets during the subprime mortgage crisis of 2007-2008 are addressed. Tests are conducted to determine whether there is excessive co-movement of CDS spreads beyond interdependence during this period compared to the previous tranquil period. Interestingly, a significant decrease is found in correlations between unexpected shocks in regional CDS markets, lending support to a claim of no contagion. Empirical evidence shows that shocks seen in CDS spreads of Asian or financial firms exhibited relatively stronger co-movement with regional shocks in excess of interdependence during this crisis. In the last part, anomalies of the Black-Scholes model are presented and explanations for the anomalies are examined. In the KOSPI 200 index option market, cross-sectional implied volatilities exhibit a smiling pattern and test results show the implied volatility is a biased estimator of future volatility. Two possible explanations for these anomalies under the Black-Scholes economy are considered: uncertainty of the volatility parameter and measurement error in variables. Simulation results show that measurement errors caused by market frictions can explain the volatility smile. In addition, empirical analysis results indicate that frictional reasons...