Credit Risk, Fraud Risk, and Corporate Bond Spreads

Exploring the main factors that determine bond spreads with respect to Treasury rates is one of the most critical issues in the corporate debt market. Credit risk has long been perceived as the most important determinant of bond spreads (Fisher, 1959). One of the most critical parameters in credit risk models is asset volatility, which includes idiosyncratic and systematic components. However, these models do not distinguish between them. Chapter 2 investigates the impact of idiosyncratic volatility on bond portfolio spreads between 2000 and 2010. While the prediction of traditional asset pricing models is that firm-specific risk should be diversified away at aggregate level, I find idiosyncratic volatility plays an incremental role in explaining bond portfolio spreads beyond the market factors.;Recent literature finds that all extant credit risk models significantly underestimate bond spreads, especially for investment grade bonds of short maturity. Chapter 4 identifies a heretofore ignored component, perceived accounting misstatement, by regressing bond spreads on the proxy of accounting misstatement propensity, while controlling for issuers' default risk and bond illiquidity risk between January 1994 and June 2002.;My thesis deepens the understanding of bond price discovery mechanisms and presents an important challenge for future research to incorporate the strong empirical relationship between idiosyncratic volatility and bond yields in asset pricing models. My thesis also sheds light on the accurate prediction of debt recovery, which is important to the valuation and hedging of risky debt and credit derivatives. Furthermore, my thesis assists in solving the credit spread puzzle by identifying a new risk factor. Overall, my thesis provides new insights into research on the corporate debt market and has important implications for academic scholars and market practitioners.;Recovery is an important measurement of credit risk additional to default probability. Chapter 3 focuses on the estimation of firm recovery after bankruptcy using the Leland and Toft (1996) model. Using a large sample of Chapter 11 filings from 1996 to 2007, I find that the recovery derived from the Leland and Toft model has strong explanatory power on the debt recovery observed in the market.