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Zurich Open Repository and Archive University of Zurich Main Library Strickhofstrasse 39 CH-8057 Zurich www.zora.uzh.ch Year: 2011 Essays on credit risk Arnold, Marc Posted at the Zurich Open Repository and Archive, University of Zurich ZORA URL: https://doi.org/10.5167/uzh-94347 Dissertation Published Version Originally published at: Arnold, Marc. Essays on credit risk. 2011, University of Zurich, Faculty of Economics. Essays on Credit Risk Dissertation for the Faculty of Economics, Business Administration and Information Technology of the University of Zurich to achieve the title of Doctor of Philosophy in Banking & Finance presented by Marc Arnold from Zurich, Switzerland approved in October 2011 at the request of Prof. Dr. Alexander Wagner Prof. Dr. Kjell Nyborg The Faculty of Economics, Business Administration and Information Technology of the University of Zurich hereby authorizes the printing of this Doctoral Thesis, without thereby giving any opinion on the views contained therein. Zurich, October 26, 2011 Chairman of the Doctoral Committee: Prof. Dr. Dieter Pfaff Table of Contents Part I: Introduction Credit Risk and Credit Derivatives 2 Summary of Research Results 3 Part II: Research Papers Private Information and Callable Credit Default Swaps 8 Macroeconomic Conditions, Growth Options and the Cross-Section of Credit Risk 57 The Impact of Managerial Control over Cash on Credit Risk and Financial Policy 133 Part III: Appendix Curriculum Vitae 184 v List of Figures Private Information and Callable Credit Default Swaps Figure 1 Market Participants 10 Figure 2 Time Structure 15 Figure 3 Loan Rate Scenarios 20 Macroeconomic Conditions, Growth Options and the Cross-Section of Credit Risk Figure 1 Cross-Section of BBB-Rated Firms 99 Figure 2 Optimal Exercise Boundary 99 Figure 3 Option Values 100 Figure 4 Default Policy and Asset Composition 100 Figure 5 Time Series of Market Leverage 101 Figure 6 Time Series of ACR 101 Figure 7 Monthly Default Rates 102 Figure 8 Monthly Expansion Rates 102 Figure 9 Time Series of Credit Spreads 103 The Impact of Managerial Control over Cash on Credit Risk and Financial Policy Figure 1 Optimal Economic Distress Policy 173 Figure 2 Shareholder Wealth Maximizing Cash Policy 173 Figure 3 Excess Cash and Asset Volatility 174 Figure 4 Corporate Cash Ratio and Asset Volatility 174 vii List of Tables Private Information and Callable Credit Default Swaps Table 1 Overview over the Low Loan Rate Scenario 20 Table 2 Overview over the High Loan Rate Scenario 29 Macroeconomic Conditions, Growth Options and the Cross-Section of Credit Risk Table 1 Baseline Parameter Choice 104 Table 2 Target Credit Spreads and Default Probabilities 105 Table 3 Implications for Credit Spreads 106 Table 4 Implications for Default Rates 107 Table 5 Implications for Leverage 108 Table 6 Credit Spreads and Leverage for Alternative Specifications 109 The Impact of Managerial Control over Cash on Credit Risk and Financial Policy Table 1 Cash Holdings and Credit Risk 175 Table 2 The Impact of Managerial Control on Excess Cash Ratios 176 Table 3 Excess Cash and the Market for Corporate Control 177 Table 4 Valuation Properties of Cash 178 Table 5 Determinants of Credit Risk 178 Table 6 Cash Holdings and Correlated Investment Opportunities 179 ix PART I: INTRODUCTION 1 1. Credit Risk and Credit Derivatives One of the main risks of granting a loan or investing in a debt security is credit risk. Credit risk is the risk that the borrower of the lending contract cannot fulfill key financial obligations, such as repaying the notional or making interest payments. Credit derivatives have been developed in response to the demand by financial institutions to hedge or diversify credit risk, to take on credit exposures at lower costs, and to manage or trade credit risk independently of the ownership of the underlying asset. Most credit derivatives take the form of a credit default swap. This contract transfers the default risk of the underlying corporation or sovereign entity from one party to another against a predetermined fixed fee. Today, many varieties of this basic contract are traded in financial markets. Credit derivatives are one of the most important financial innovation of the last decade. In a relatively short time, they have grown to become a large segment of financial markets. From 2001 to 2009, the outstanding notional amount increased from an estimated $919 billion to $30 trillion (ISDA, 2010). As a result, credit risk has gradually changed from an initially illiquid risk to one that is traded much like other fundamental factors of financial risk such as equity, currency, or interest rate risk. The liquid trading of credit risk offers many opportunities for financial institutions and compa- nies. It helps them to manage the credit risk exposure by allowing to insure against a deteriorating credit quality of their borrowers. For financial firms, managing concentration risk is of particular interest. The standard treatment has been to screen new loan applicants regarding the degree of additional concentration risk an approval could impose on the current lending portfolio (Batten and Hogan, 2002). Credit derivatives have the potential to implement a much more flexible approach to managing concentration risk. Large exposures to concentrated borrowers can simply be replaced with smaller and more diversified exposures. Another potential benefit of credit derivatives is their use in the management of liquidity risk. By transferring credit risk to a counterparty, the original lender may be able to substitute cash for an illiquid asset, or to conserve costly regulatory capital. The frequent trading of credit derivatives also allows lenders, borrowers, and investors to directly compare prices of bonds or loans with market prices of credit risk. Hence, credit derivatives add transparency to the pricing of credit risky claims by offering a benchmark. The recent financial crisis, however, painfully reveals that the liquid trading of credit risk brings about not only opportunities but also challenges. Academics and practitioners argue that credit risk transfer may induce problems related to asymmetric information. For example, incentives of lenders to analyze and monitor credit quality could be reduced if they have the ability to hedge their credit exposure. Lower credit discipline could then decrease overall credit quality. While asymmetric information problems exist in most markets, the credit derivatives market is particularly vulnerable. The reason is that lending firms have a much closer relationship to their borrowers than outside 2 investors. Hence, by the nature of the credit business, most of the major players in this market are insiders. Furthermore, during the recent crisis, many commentators have raised the concern that while credit derivatives may allow for risk reduction at the individual entity level, it is not clear how they affect the aggregate risk in the economy at the systemic level. Instefjord (2005), for example, shows that credit derivatives enhance risk sharing but, at the same time, also lead to further acquisition of risk which eventually destabilizes the banking sector. Similarly, Duffee and Zhou (2001) argue that the introduction of credit risk transfer can cause the markets for other loan risk-sharing to break down. The adequate pricing of credit risk is another unresolved matter. Even though this field has witnessed a tremendous acceleration in research effort aiming at a more profound understanding, modeling and pricing of credit risk, many problems are still discussed. For example, observed credit spreads are high relative to the empirical default rates and recovery rates, known as the credit spreads puzzle (Elton, Gruber, Agrawal, and Mann, 2001; Huang and Huang, 2003; Chen, 2010). Moreover, relatively little is known about how cross-sectional differences in firm characteristics affect credit risk. From an academic viewpoint, the main objective of research on credit risk must be to contribute to the discussions of the above mentioned open challenges to support the evaluation of adequate solutions. The present dissertation follows this avenue by rigorously analyzing three important open issues of credit risk. I am grateful to my supervisor Alexander Wagner for his great support and helpful comments on all three papers which have led to essential improvements. During the process of writing, I have also profited from valuable discussions and remarks by, among others, Rajna Gibson, Kjell Nyborg, and Ramona Westermann. 2. Summary of Research Results This dissertation contains three independent research papers which are briefly outlined in this section. The first paper “Private Information and Callable Credit Default Swaps” visualizes a specific opportunity and challenge of the introduction of a credit derivatives market. Credit derivatives provide banks with the opportunity to transfer credit risk beyond lending constraints to external investors. The challenge, however, is that standard credit risk transfer also introduces information asymmetry costs. If a bank can not credibly signal loan quality, the transfer negatively affects its incentives to screen and monitor the underlying loans which causes overinvestment, or a market 3 breakdown. I show that simple structuring of credit derivatives solves this problem. The basic idea is that credit risk should be transferred by using a callable credit default swap. As the bank can signal loan quality by expressing its readiness to pay for the implicit call feature, screening and monitoring incentives

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