The Journal of Finance

Do Credit Spreads Reflect Stationary Leverage Ratios?

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00395

Pierre Collin‐Dufresne, Robert S. Goldstein

Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean‐reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low‐leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative‐grade debt, consistent with recent empirical findings.

Do Bonds Span the Fixed Income Markets? Theory and Evidence for Unspanned Stochastic Volatility

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00475

Pierre Collin‐Dufresne, Robert S. Goldstein

Most term structure models assume bond markets are complete, that is, that all fixed income derivatives can be perfectly replicated using solely bonds. How ever, we find that, in practice, swap rates have limited explanatory power for returns on at‐the‐money straddles—portfolios mainly exposed to volatility risk. We term this empirical feature unspanned stochastic volatility (USV). While USV can be captured within an HJM framework, we demonstrate that bivariate models cannot exhibit USV. We determine necessary and sufficient conditions for trivariate Markov affine systems to exhibit USV. For such USV models, bonds alone may not be sufficient to identify all parameters. Rather, derivatives are needed.

Portfolio Choice over the Life‐Cycle when the Stock and Labor Markets Are Cointegrated

Published: 09/04/2007   |   DOI: 10.1111/j.1540-6261.2007.01271.x

LUCA BENZONI, PIERRE COLLIN‐DUFRESNE, ROBERT S. GOLDSTEIN

We study portfolio choice when labor income and dividends are cointegrated. Economically plausible calibrations suggest young investors should take substantial short positions in the stock market. Because of cointegration the young agent's human capital effectively becomes “stock‐like.” However, for older agents with shorter times‐to‐retirement, cointegration does not have sufficient time to act, and thus their human capital becomes more “bond‐like.” Together, these effects create hump‐shaped life‐cycle portfolio holdings, consistent with empirical observation. These results hold even when asset return predictability is accounted for.

Dividend Dynamics and the Term Structure of Dividend Strips

Published: 01/27/2015   |   DOI: 10.1111/jofi.12242

FREDERICO BELO, PIERRE COLLIN‐DUFRESNE, ROBERT S. GOLDSTEIN

Many leading asset pricing models are specified so that the term structure of dividend volatility is either flat or upward sloping. These models predict that the term structures of expected returns and volatilities on dividend strips (i.e., claims to dividends paid over a prespecified interval) are also upward sloping. However, the empirical evidence suggests otherwise. This discrepancy can be reconciled if these models replace their proposed dividend dynamics with processes that generate stationary leverage ratios. Under such policies, shareholders are forced to divest (invest) when leverage is low (high), which shifts risk from long‐ to short‐horizon dividend strips.

On the Relative Pricing of Long‐Maturity Index Options and Collateralized Debt Obligations

Published: 11/19/2012   |   DOI: 10.1111/j.1540-6261.2012.01779.x

PIERRE COLLIN‐DUFRESNE, ROBERT S. GOLDSTEIN, FAN YANG

We investigate a structural model of market and firm‐level dynamics in order to jointly price long‐dated S&P 500 index options and CDO tranches of corporate debt. We identify market dynamics from index option prices and idiosyncratic dynamics from the term structure of credit spreads. We find that all tranches can be well priced out‐of‐sample before the crisis. During the crisis, however, our model can capture senior tranche prices only if we allow for the possibility of a catastrophic jump. Thus, senior tranches are nonredundant assets that provide a unique window into the pricing of catastrophic risk.

The Determinants of Credit Spread Changes

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00402

Pierre Collin-Dufresn, Robert S. Goldstein, J. Spencer Martin

Using dealer's quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross‐correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply/demand shocks that are independent of both credit‐risk factors and standard proxies for liquidity.

Identification of Maximal Affine Term Structure Models

Published: 04/01/2008   |   DOI: 10.1111/j.1540-6261.2008.01331.x

PIERRE COLLIN‐DUFRESNE, ROBERT S. GOLDSTEIN, CHRISTOPHER S. JONES

Building on Duffie and Kan (1996), we propose a new representation of affine models in which the state vector comprises infinitesimal maturity yields and their quadratic covariations. Because these variables possess unambiguous economic interpretations, they generate a representation that is globally identifiable. Further, this representation has more identifiable parameters than the “maximal” model of Dai and Singleton (2000). We implement this new representation for select three‐factor models and find that model‐independent estimates for the state vector can be estimated directly from yield curve data, which present advantages for the estimation and interpretation of multifactor models.