Defaultable Bond Pricing Under Imperfect Market Conditions

As an important ingredient of the financial market,defaultable bonds play an important role in increasing financing instruments and promoting economic development.Thus,the fluctuation of defaultable bond prices has always been the focus for investors.Traditional theory documents that there is no market frictions,and the defaultable bond risk is mainly from the default.However,during financial crisis,the huge losses promotes scholars to reconsider the construction of risk in defaultable bonds.Therefore,this study identifies imperfect market conditions for defaultable bond pricing and proposes a generalized bond pricing model.Under this framework,we analyze the sources of risk and its impact on defaultable bond prices and returns using the US and Chinese markets as samples.In the first part,we propose a generalized bond pricing model under imperfect market conditions.By introducing an informed trading model into the reduced bond pricing theory,a new bond pricing model considering both credit risk and trading risk has been proposed.Then,we analyze the action of information precision,capital constraints and imperfect competition in trading losses.Our model reveals that the downside trend is the main reason that causes the investors' information precision and risk tolerance level drop.In the second part,we empirically test the influence of downside risk in bond returns.On the one hand,we show that downside risk explains a larger part of variation in yield spreads than liquidity risk does by the generalized method of moments.Meanwhile,its explanatory ability has been significantly improved with the increase of credit risk.On the other hand,Fama-French portfolio analysis is utilized to verify the cross-sectional predictive power of downside risk on excess returns.We also introduce the downside risk factor into the prevalent multi-factor corporate bond pricing model,and find that this factor has economically and statistically significant risk premia.In the third part,we widely consider the predictive effect of macro information on corporate bond returns based on the first two parts.First,we investigate the additional predictive power of macro information on interest rates,and the results show that the monetary policy cannot improve the predictive performance of model,while market activities can.Then,we examine the predictive ability of macro information on corporate bond excess returns.A new method is utilized to extract the predictive index from large-scale variables,which forecasts excess returns better.We also show that the macro information affects excess returns by affecting the level of credit risk and downside risk for bonds with lower credit levels.In the fourth part,we analyze the effect of the correlation between credit risk and downside risk in corporate bond prices under extreme conditions.We first test the correlation for different periods.Then,we use Copula function to estimate the probability of occurrence of risk events in the pricing model proposed in the first part.Next,using numerical examples,we document that the varying correlation between default and trade explains the great and persistent loss in a financial crisis.The main contributions of this study are as follows: First,we propose a defaultable bond pricing model based on market microstructure theory,providing a new interpretation of the downside risk premium.Second,based on the trading model,we identify the predictive ability of downside risk to excess return,which improves the multi-factor bond pricing model.Third,a new method has been proposed to extract effective information from large-scale variables,so as to fully consider the predictive power of macro information on returns.Finally,our empirical part takes the US and Chinese markets as samples,which enhances the robustness of our main conclusions,and analyzes features in Chinese bond market.