Working Papers (Drafts available upon request)
Default Risk Spillovers and Intra-Industry Return Predictability (Job Market Paper)
Abstract: Stocks that are far from the most distressed stocks in their industry earn significantly higher future returns. I connect less distressed stocks to the most distressed stocks in their industry through β−distance and common institutional ownership. Disconnectedness forecasts higher future returns, especially when returns of the most distressed stocks are high. A one standard deviation increase in disconnectedness from the most distressed stocks increases next month returns by 0.53%. A strategy that buys stocks that are far from the distressed firms and sells stocks near the distressed firms yields 7.44% annualized Fama French five-factor alpha with t-statistic 3.22. I argue that this predictability arises through an intra-industry default risk propagation mechanism, which affects the liquidation value of connected firms’ assets. Predictability is strongest in industries with lowest levels of asset redeployability. Taken together, these findings suggest that intra-industry distress risk spillovers predict equity returns.
Default Risk and Informed Trading: Evidence from the CDS Market (Joint with Gaurav Kankanhalli)
Abstract: In a sample of the 520 most frequently-traded single-name non-sovereign credit default swaps (CDS), we find evidence of a non-monotonic relationship between informed trading (proxied by PIN ) and quoted CDS spreads, as a function of default risk (proxied by reduced-form estimates of default probability, or DP ). Unconditionally, higher PIN is associated with higher quoted CDS spreads, as predicted by models with market makers facing an adverse selection problem. However, conditional on DP, the marginal effect of PIN on spreads decreases. This is consistent with the notion that at higher levels of default risk the private signals of informed traders have less value, reducing the adverse selection problem faced by the market maker and, at margin, reducing spreads. VAR analysis confirms that the private signal of informed traders is informative about future default risk, as lagged PIN predicts lead DP, but only at short horizons. An investment strategy that buys low PIN low DP stocks and sells high PIN high DP stocks earns average daily returns of 0.13% and average daily Fama French three-factor alpha of 0.17%, with t-statistic 4.86. In summary, our results provide new insights into the joint dynamics of informed trading and default risk, and their implications on CDS spreads and equity returns.