Do Investors Price Expected Liquidity?, with P. Schuster (work-in-progress)
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.