Essays on credit risk
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This dissertation examines the determinants of credit spreads. The purpose and contribution of this dissertation is to provide a more comprehensive and coherent view of credit risk valuation. Specifically, I examine the effects of previously overlooked factors (in addition to conventional factors such as market financing costs, firm leverage, and firm risk) on credit risk using credit default swap (CDS) rates that better reflect associated credit risk. I undertake this study through both theoretical exploration and empirical examination. On the theoretical front, I present a structural credit risk model that explicitly considers both macro-economic conditions and firm fundamentals. I show that the model predicts more appropriate levels of credit spreads across all credit rating classes than the existing structural models and produces the empirically observed upward-sloping term structure of credit spreads for high-yield bonds that most other models fail to explain. On the empirical front, I capitalize on the advantage of CDS spreads as a better measure of credit risk than other existing measures. Using this measure, I first test and verify some of our model’s predictions, namely, both macro-economic conditions and firm characteristics have significant effects on credit spreads. The most notable finding is that credit spreads increase with investor sentiment. The second part of my empirical investigation examines the role of imperfect information in the CDS market. Using several proxies (especially analyst forecast dispersion) for transparency, I find that credit spreads decrease with transparency, but this effect is most pronounced for issuers with low disclosure costs. I also find significant liquidity effects and illiquidity spillover in the CDS market, contrary to the conventional wisdom.