| In this dissertation, I study various aspects of credit risk in the corporate bond market. Chapter 1 begins with a short review of the history of the rating agencies since their inception, and examines their main product---credit ratings. I survey the literature related to various applications of ratings, and critically analyze the evidence on their usefulness in detecting credit quality changes. The chapter concludes with suggestions for improving the information content of credit ratings.;In Chapter 2, I seek to identify the systematic risks priced in corporate bonds by taking a direct approach to capture aggregate default, recovery and liquidity risks. I find that, in general, consistent macroeconomic and stock market risk factors can explain a significant amount of the variations in these risk proxies. Another important contribution of this study is to provide independent empirical support for using structural models for modeling credit risks because these models incorporate systematic risks explicitly.;In theory, the effect of systematic risk on corporate bond spreads is non-linear. In practice, however, researchers have used linear factor model to approximate the market component of the bond spreads. Chapter 3 considers the estimation bias introduced by such linearization. This chapter is based on joint work with Deborah Lucas. The theoretically correct price reflects default and market risks, but no premium for liquidity risk. However, using simulated data from a continuous-time setting and removing a default spread and market spread by linear approximation, we find a significant unexplained residual, which, in the literature, is attributed to liquidity risk rather than to model mis-specification. All else equal, the bias increases homogeneously in systematic and idiosyncratic asset risk, the leverage ratio, and debt maturity. Hence, our findings raise serious concerns about interpreting the residual spread. |
