The Journal of Finance

Special Repo Rates

Published: 06/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb02692.x

DARRELL DUFFIE

This article provides the causes and symptoms of special repo rates in a competitive market for repurchase agreements. A repo rate is, in effect, an interest rate on loans collateralized by a specific instrument. A “special” is a repo rate significantly below prevailing market riskless interest rates. This article shows that specials can occur when those owning the collateral are inhibited, whether from legal or institutional requirements or from frictional costs, from supplying collateral into repurchase agreements. Specialness increases the equilibrium price for the underlying instrument by the present value of savings in borrowing costs associated with the repo specials.

Presidential Address: Asset Price Dynamics with Slow‐Moving Capital

Published: 07/15/2010   |   DOI: 10.1111/j.1540-6261.2010.01569.x

DARRELL DUFFIE

I describe asset price dynamics caused by the slow movement of investment capital to trading opportunities. The pattern of price responses to supply or demand shocks typically involves a sharp reaction to the shock and a subsequent and more extended reversal. The amplitude of the immediate price impact and the pattern of the subsequent recovery can reflect institutional impediments to immediate trade, such as search costs for trading counterparties or time to raise capital by intermediaries. I discuss special impediments to capital formation during the recent financial crisis that caused asset price distortions, which subsided afterward. After presenting examples of price reactions to supply shocks in normal market settings, I offer a simple illustrative model of price dynamics associated with slow‐moving capital due to the presence of inattentive investors.

Swap Rates and Credit Quality

Published: 07/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb02712.x

DARRELL DUFFIE, MING HUANG

This article presents a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (that is, a liability). The impact of credit‐risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps.

An Econometric Model of the Term Structure of Interest‐Rate Swap Yields

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb01111.x

DARRELL DUFFIE, KENNETH J. SINGLETON

This article develops a multi‐factor econometric model of the term structure of interest‐rate swap yields. The model accommodates the possibility of counterparty default, and any differences in the liquidities of the Treasury and Swap markets. By parameterizing a model of swap rates directly, we are able to compute model‐based estimates of the defaultable zero‐coupon bond rates implicit in the swap market without having to specify a priori the dependence of these rates on default hazard or recovery rates. The time series analysis of spreads between zero‐coupon swap and treasury yields reveals that both credit and liquidity factors were important sources of variation in swap spreads over the past decade.

Funding Value Adjustments

Published: 10/26/2018   |   DOI: 10.1111/jofi.12739

LEIF ANDERSEN, DARRELL DUFFIE, YANG SONG

In this paper, we demonstrate that the funding value adjustments (FVAs) of major dealers are debt overhang costs to their shareholders. To maximize shareholder value, dealer quotations therefore adjust for FVAs. Our case studies include interest‐rate swap FVAs and violations of covered interest parity. Contrary to current valuation practice, FVAs are not themselves components of the market values of the positions being financed. Current dealer practice does, however, align incentives between trading desks and shareholders. We also establish a pecking order for preferred asset financing strategies and provide a new interpretation of the standard debit value adjustment.

Benchmarks in Search Markets

Published: 06/01/2017   |   DOI: 10.1111/jofi.12525

DARRELL DUFFIE, PIOTR DWORCZAK, HAOXIANG ZHU

We characterize the role of benchmarks in price transparency of over‐the‐counter markets. A benchmark can raise social surplus by increasing the volume of beneficial trade, facilitating more efficient matching between dealers and customers, and reducing search costs. Although the market transparency promoted by benchmarks reduces dealers' profit margins, dealers may nonetheless introduce a benchmark to encourage greater market participation by investors. Low‐cost dealers may also introduce a benchmark to increase their market share relative to high‐cost dealers. We construct a revelation mechanism that maximizes welfare subject to search frictions, and show conditions under which it coincides with announcing the benchmark.

Modeling Sovereign Yield Spreads: A Case Study of Russian Debt

Published: 02/12/2003   |   DOI: 10.1111/1540-6261.00520

Darrell Duffie, Lasse Heje Pedersen, Kenneth J. Singleton

We construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring, and allows for compensation for illiquidity. Using a new and relatively efficient method, we estimate the model using Russian dollar‐denominated bonds. We consider the determinants of the Russian yield spread, the yield differential across different Russian bonds, and the implications for market integration, relative liquidity, relative expected recovery rates, and implied expectations of different default scenarios.

Frailty Correlated Default

Published: 09/28/2009   |   DOI: 10.1111/j.1540-6261.2009.01495.x

DARRELL DUFFIE, ANDREAS ECKNER, GUILLAUME HOREL, LEANDRO SAITA

The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm‐by‐firm default probabilities.

Common Failings: How Corporate Defaults Are Correlated

Published: 01/11/2007   |   DOI: 10.1111/j.1540-6261.2007.01202.x

SANJIV R. DAS, DARRELL DUFFIE, NIKUNJ KAPADIA, LEANDRO SAITA

We test the doubly stochastic assumption under which firms' default times are correlated only as implied by the correlation of factors determining their default intensities. Using data on U.S. corporations from 1979 to 2004, this assumption is violated in the presence of contagion or “frailty” (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time‐series properties of default intensities. The data do not support the joint hypothesis of well‐specified default intensities and the doubly stochastic assumption. We find some evidence of default clustering exceeding that implied by the doubly stochastic model with the given intensities.