Three essays on debt pricing

Xu, Hui

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https://hdl.handle.net/2142/101268 Copy

Description

Title

Three essays on debt pricing

Author(s)

Xu, Hui

Issue Date

2018-04-03

Director of Research (if dissertation) or Advisor (if thesis)

Pennacchi, George

Doctoral Committee Chair(s)

Pennacchi, George

Committee Member(s)

• Johnson, Timothy C.
• Almeida, Heitor
• Bernhardt, Daniel

Department of Study

Economics

Discipline

Economics

Degree Granting Institution

University of Illinois at Urbana-Champaign

Degree Name

Ph.D.

Degree Level

Dissertation

Keyword(s)

• Consumer Debt
• Household Debt
• Asset Pricing
• Corporate Finance
• Capital Structure

Abstract

This dissertation contains three chapters that study risky debt pricing. The first chapter studies defaultable consumer debt in general equilibrium. The second and third chapters study corporate debt in partial equilibrium. Below are the individual abstracts for each chapter. Chapter 1: What Drives the Consumer Credit Spread? An Explanation Based on Rare Event Risk and Belief Dispersion. What drives consumers borrowing/lending and the credit spread over their debt? This paper offers a novel explanation based on rare event risk and belief dispersion in a dynamic general equilibrium model. Heterogeneous beliefs drive consumers to borrow, but the market is incomplete and subject to rare event risk and thus default endogenously occurs in equilibrium. The paper derives the credit spread in closed form and yields a credit spread similar to real data when the model is calibrated. The model also well captures the relationship between belief dispersion, risk-free rate and credit spread. It shows that belief dispersion, rare event risk and wealth distribution together drive both credit spread and risk-free rate. An increase in either rare event risk or belief dispersion leads to a higher credit spread and a lower risk-free rate. However, the underlying mechanisms are quite different, as the former (rare event risk) is due to substitution effect while the latter (belief dispersion) is due to wealth effect. The paper also makes a contribution to the literature on rare disaster by endogenizing default and augments Barro's argument on the countervailing effects of rare disasters on interest rates. Chapter 2: Scooping Up Own Debt On the Cheap: The Effect Of Corporate Bonds Buyback on Firm's Credit Condition The paper constructs a structural model to study the effect of corporate bonds buyback on the firm's credit conditions. The model implies that the firm strategically choose how much debt to buy back and the buyback reduces the firm's probability of default. In contrast to commonly perceived deleverage channel, the model highlights a novel channel that buying back bonds on the cheap transfers value from bondholders to equity holders and incentivizes the equity holders to choose a much lower assets value to declare default. The lowered default boundary furthermore reduces debt overhang and increases return to equity. The virtuous cycle does not stop until the marginal benefit of bonds buyback equals its marginal cost. The model also implies that when bonds market liquidity dries up, the firm should buy back more bonds, as the shortage of liquidity is independent of the firm's fundamental but depresses the market price of bonds. The paper also provides empirical evidences for the implications. Chapter 3: How to roll over debt? The Effect of Risky Bond Yield Curve on Optimal Rollover Strategy This chapter studies how firms can exploit the risky bond yield curve (treasury yield curve plus term structure of credit spread) to manage the maturity profile of new debt issuance. In contrast to existing literature, I \emph{shut down} the rollover frequency channel, but highlight the clean effect of the maturity profile of new debt issuance on firm's credit risk and value. A better rollover strategy takes into account of the curvature, level as well as the sensitivity (market depth) of the risky bond yield curve. The model implies that the firms should disperse maturity dates of new debt issuance when the risky bond yield curve is concave; they also should trade off the level against the sensitivity of the risky bond yield curve when issuing new debt. The consequent rollover strategy assuages both adverse assets shocks and liquidity shocks better. The model derives multiple testable implications and accentuate the endogenous interaction between rollover strategy and risky bond yield curve.

Graduation Semester

2018-05

Type of Resource

text

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Copyright and License Information

Copyright 2018 HUI XU

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