Working Papers
We suggest a procedure to predict individual stock liquidity and study the relation between stock liquidity forecasts and average stock returns. Our forecast model reduces the root-mean-squared error by 12% for the Amihud (2002) liquidity measure compared to realized stock liquidity in the previous month. Our liquidity forecasts capture economically large changes in liquidity and improve in accuracy over time. Whereas liquidity measures provide mixed empirical results in asset pricing tests, we find a strong relation between expected changes in liquidity and average stock returns. Sorting portfolios according to the expected change in illiquidity in the next period leads to a monthly excess return of the long-short portfolio of 1% for equally-weighted and 0.8% for value-weighted portfolios. Our results are robust to controlling for various predictors of stock returns in Fama and MacBeth (1973) cross-sectional regressions and to using the effective spread as an alternative liquidity measure. The large return premium of expected illiquidity changes can be explained with portfolio re-allocations of investors with heterogeneous investment horizons. Consistent with the clientele effect of Amihud and Mendelson (1986), mutual funds with short investment horizons sell (buy) stocks for which liquidity is expected to deteriorate (improves). Funds with longer horizons, the natural counterpart, do not react on expectations but base their portfolio decisions on realized illiquidity, leading to a temporal mismatch between supply and demand.
We examine the relation between the risk of failure and average stock returns in light of two potential sources of failure risk; the probability that a firm will fail and shareholders' losses conditional on failure. We suggest a simple model for predicting shareholder losses upon default and show that our forecast estimates predict realized default outcomes for shareholders. Forming portfolios on our forecast estimates, we find that five-factor alphas increase for higher levels of expected shareholder losses and that the negative alphas for highly distressed stocks are no longer economically or statistically significant if shareholders expect high default losses.
The paper uses information about the risk components contained in a credit rating to answer a central question in the credit rating literature. Even though credit ratings exist since the early 20th century, the question of whether credit ratings provide investors with information rather than performing a regulatory function remains unanswered. This is primarily due to a measurement problem as credit rating changes always have regulatory implications that make it difficult to isolate the effect of a potential information channel. Credit rating agencies publish information on the default likelihood and expected default losses that they assume to calculate a particular credit rating. As this additional information has no regulatory implications, it allows to empirically study the information channel of credit ratings. The empirical results suggest that credit and equity market investors use credit ratings as a source of private information.
The paper empirically studies the expectations of investors concerning the outcome of large bank failures. Despite the global financial crises of 2008, very few large financial institutions have declared bankruptcy, making it difficult to empirically study the losses that investors incur in case of a default. Instead of using data on realized default events of large financial institutions, we focus on expectations that credit market investors have with respect to bankruptcy losses. To measure these expectations, we use the information that is contained in the market prices of credit default swap spreads. We find that investors expect financial institutions that fail to have more positive creditor outcomes that in case of an industrial firm and that expected bankruptcy losses are related to proxies for government support. These findings suggest that investors not only expect that governments bail-out large financial institutions, but also that governments compensate investors of financial institutions in case of a default event.