Throughout the 1990s there were a number of financial crises that led to concerns about the operation and stability of financial markets (the Mexican peso collapse of 1994, the East Asian crisis of 1997, the Russian default of 1998). In all of these events, the initial shock of a country affected many other countries causing increases in volatility and co-movement of their financial asset markets. The term contagion has been used to address these events, and in particular the spread of a financial crisis. Furthermore, in recent years there were a number of domestic shocks (internet bubble, collapses of Enron, WorldCom), that were followed by a flight to quality and widening of credit spreads of the overall corporate bond market due to the desire of investors to hold safer assets.
A number of theories have been proposed to explain these episodes, and in general the propagation of shocks within and across markets. These are models based on pure information transmission [King and Wadhwani (1990), Collin-Dufresne, Golstein, and Helwege (2004)], correlated liquidity shocks [Kyle and Xiong (2001)], the rebalancing activity of risk averse agents [Kodres and Pritsker (2002)], industry and counterparty structures [Lang and Stulz (1992), Jarrow and Yu (2001)], as well as on the trading patterns of investors [Barberis and Shleifer (2003)]. Despite the abundance of explanations, no theory has yet emerged to dominate the field, and few papers have tried to empirically disentangle the implications of these models. Important, unobserved questions include: What is the channel of propagation of a shock during a time of crisis? Which parties are affected by these events? Why do some events have more profound effects than others? These questions are the motivation for this dissertation research. To answer them, this project examines the implications of various shocks on the U.S. Treasury and corporate bond market. Specifically, it will investigate the effects of firm-specific (Chapter 11 bankruptcies, credit rating downgrades) and market-wide shocks (stock market downturns) and will test the implications of the above models of contagion in an effort to discover the dominant channels of propagation of a shock within a market. Testing these models in a bond setting allows permits the investigator to contrast and compare all channels of contagion and, at the same time, gives another perspective as to the propagation of a shock (in contrast to the more standard examinations from the equity and international markets). Furthermore, the results from these tests can possibly provide useful insights in regards to other major issues related to the bond markets, such as the determinants of credit spread changes and the importance of liquidity.
This dissertation improvement award will be used to buy the FISD-NAIC bond database that is essential for the completion of this project. The Fixed Investment Securities Database (FISD) consists of issuer- and issuer- specific variables on all U.S. corporate bonds maturing in 1990 or later. The National Association of Insurance Commissioners (NAIC) consists of detailed information on all transactions by insurance companies from 1995 until 2002. This database is provided by the Fixed Income Research Program at the University of Houston, College of Business Administration and is the most comprehensive collection of publicly offered U.S. Corporate and Agency bond data available.
Broader Impact: The results of this research promise to provide a better understanding of the propagation of a crisis across and within financial markets. This can be very beneficial to a number of parties in light of the crises that have occurred in recent years. Risk managers and portfolio managers can use this information in their investment and risk management decisions. For example, if liquidity is the dominant reason for the propagation of shocks then risk managers should appreciate the importance of holding liquid assets, especially at times of crises. Finally, policy regulators can benefit by using this information in their efforts to limit the spread of crises in the future.
