Doctor of Philosophy (PhD)
School of Business and Economics
Dissertation Committee (Chair)
This dissertation comprises three essays on default risk in capital markets exploring (a) failure risk of hedge funds, (b) pricing in equity option markets, and (c) relationship between option and credit default swap markets, respectively, with a particular focus on the recent financial crisis.
The first essay “The role of Excess Leverage in Hedge Funds Failure” investigates the role of financial leverage, including the use of margins and derivatives, in the hedge funds failure during the 2008 financial crisis. Motivated by failure of the two Bear Sterns hedge funds, this paper examines why some hedge funds failed during and after the recent financial crisis, and why some also survived. Using a 15-year panel dataset of 17,202 hedge funds from the Lipper TASS Hedge Fund database, the empirical analysis shows that during the crisis period, financial leverage is more significant in increasing the probability of failure, whereas it becomes insignificant during non-crisis periods. Moreover, hedge funds following specific styles such as “Emerging Markets”, “Equity Market”, “Long/Short Equity Hedge”, and “Multi-strategy” are more likely to fail during the financial crisis.
The second essay “Is Default Risk Priced in Equity Options?” explores the impact of default risk on equity option pricing. The impact is studied in detail by empirically examining to what extent the firm-specific default risk matters in pricing individual equity options. Since credit default swaps (CDS) are similar to put options in that both offer a low cost and effective protection against downside risk, we use CDS spread as credit risk proxy to investigate the effects of default risk on put pricing. By examining an exhaustive sample of US-listed firms with both CDS and put options data available over the period from 2002 to 2010, and studying the primary determinants of option implied volatility (IV) cross-sectionally and over time, the findings show that default risk is a significant factor in the prices of equity options. The results remain significant after controlling for firm-specific and macroeconomic factors, and endogeneity.
The third essay “The Impact of Using CDS in Forecasting Option-Implied Volatility” addresses the issue of forecasting IV which is of interest to option market participants, who routinely formulate volatility and option price forecasts for trading and hedging purposes. Credit risk matters for option pricing since options are valued on firms with significant trading liquidity, yet subject to default risk, similar to liquidity risk. This essay particularly explores whether better out-of-sample forecasts for IV can be developed using lagged credit risk measures. Various time-series IV forecasts show that inclusion of default risk as measured by CDS can significantly improve out-of-sample performance, measured through decreased mean squared error (MSE) as well as smaller root mean squared error (RMSE).
Samarbakhsh, Laleh, "Three Essays on Default Risk in Capital Markets" (2015). Theses and Dissertations (Comprehensive). 1741.