Editor’s Letter

Effective risk management for fixed income portfolios and regulatory stress tests requires sophisticated sensitivity analysis. Mortgage-backed securities contain complex optionality associated with prepayment uncertainty and conditional changes in option-adjusted spreads that may reflect important economic sources of value omitted from model specification (i.e., changes in liquidity and credit risks). We begin this issue of The Journal of Fixed Income with an article by Alexander Bogin, Nataliya Polkovnichenko, and William Doerner that provides a methodology for calculating the valuation changes due to these shocks and evidence that they are economically significant.

In commercial mortgage-backed securities, default risk is the major risk factor. In the next article, Xi Chen, Eric Ghysels, and Roland Telfeyan advocate an observation-driven frailty model for predicting commercial real estate mortgage defaults that tracks origination and originator characteristics. Their empirical evidence suggests superior performance.

In the next article, Jack Clark Francis, Christopher Hessel, and Jun Wang examine the relationship between high-yield spreads and an exhaustive list of economic variables. Their evidence indicates that the growth of high-yield spread has embedded information concerning future economic growth measures, industry inventories, sales, and employment. In another forecasting article, Daniel Klein, Elena Nikitina, and Jean-Christophe Curtillet employ a Baysian model search that outperforms competing methods for predicting swap spreads.

The interaction between the bond and stock markets presents opportunities for hedging, alpha generation, and asset allocation strategies. In the next article, Stephen Christophe, Michael Ferri, Jim Hsieh, and Tao-Hsien Dolly King explore the effect of short selling in the stock market on corporate bond returns. They find that firms associated with large short positions experience negative earnings surprises, higher credit risk, and reduced dividends. Hence, short sales do provide significant information about valuation.

Given the new normal of low to negative interest rates in the current global economic environment, Brownian motion may be more descriptive than the typical geometric Brownian motion assumption. Jian Sun, Qiankun Niu, Shinan Cao, and Peter Carr provide such a model for the options implied volatility curve in closed form.

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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