Editor’s Letter

For many years before 2008, markets were awash in liquidity. Investors were seduced by the assumption that liquid markets were to be expected as a result of financial innovation. The perception and price of liquidity risk has certainly changed since the financial market crisis of 2008. Therefore, we begin this issue of The Journal of Fixed Income with an article by Ren-Raw Chen and Bo Li, “A Closed-Form Solution to the Liquidity Discount Problem: With an Application to the Liquidity Crisis,” that provides a liquidity discount model that can explain large price declines. The authors demonstrate that payoff convexity is positively related to liquidity discounts.

A continuing issue posed by the financial market crisis is banking regulation and the notion of businesses that are too big to fail. In the next article, “Implicit Government Guarantee and the CDS Spreads,” Natalia Beliaeva, Shahriar Khaksari, and Georges Tsafack find that there is an implicit government guarantee priced into credit default swap (CDS) spreads. Their evidence suggests that this guarantee reduces the CDS spread by 16.11 basis points for large companies and 3.73 for small ones. Another relevant topic from the crisis is the evolving implementation of the Basel Accord. Oliver Blümke provides evidence supporting the assumption of and proposing a parametric function for an inverse relationship between the probability of default and the asset correlation parameter (the cyclicality of default rates) in “On the Basel Accord’s Inverse Relationship between Default Probability and Asset Correlation: An Empirical Study.”

In the next article, “Loss Severity on Residential Mortgages: Evidence from Freddie Mac’s Newest Data,” Laurie Goodman and Jun Zhu analyze more than 17 million single-family mortgages that have experienced a credit event. They find useful data on mortgage insurance, preset severities versus actual losses by loan-to-value ratio, loan size, real-estate-owned sales, and state of origin. Then, in their article, “Forecasting Sovereign Default Risk with Merton’s Model,” Johan Duyvesteyn and Martin Martens employ the Merton structural default model for sovereign default risk and demonstrate that CDS spreads react to changes in the inputs and outputs of the model.

Bond-stock hedging strategies require knowledge of the correlation dynamics between CDS spread changes and stock returns. Zilong Liu, Xiaoling Pu, and Xinlei Zhao decompose the unexpected equity returns into cash flow and discount rate news and investigate the effect on correlations in their article, “What Moves the Correlation between the Equity and Credit Default Swap Markets?” They find that discount rate news explains the larger part of the correlation, but firms with more cash flow news do exhibit stronger correlations between equity returns and credit spread changes.

We hope you enjoy this issue of The Journal of Fixed Income. Your continued support of the journal is greatly appreciated.

Stanley J. Kon

Editor

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