Systemic Default and Return Predictability in the Stock and Bond Markets

Charles A. Dice Center Working Paper No. 2016-2

Fisher College of Business Working Paper No. 2016-03-02

58 Pages Posted: 27 Jan 2016

See all articles by Jack Bao

Jack Bao

University of Delaware - Department of Finance

Kewei Hou

Ohio State University (OSU) - Department of Finance

Shaojun Zhang

The Ohio State University

Date Written: January 26, 2016

Abstract

Using a structural model of default, we construct a measure of systemic default defined as the probability that many firms default at the same time. Our estimation accounts for correlations in defaults between firms through common exposures to shocks. The systemic default measure spikes during recession periods and is strongly correlated with traditional credit-related macroeconomic measures such as the default spread and VIX. Furthermore, our measure predicts future equity and corporate bond index returns, particularly at the one-year horizon, and even after controlling for many traditional return predictors such as the dividend yield, default spread, inflation, and tail risk. These predictability results are robust to out-of-sample tests.

Keywords: Systemic risk, Joint default, Predictability, Stock returns, Bond returns

JEL Classification: E32, G12, G13, G17

Suggested Citation

Bao, Jack and Hou, Kewei and Zhang, Shaojun, Systemic Default and Return Predictability in the Stock and Bond Markets (January 26, 2016). Charles A. Dice Center Working Paper No. 2016-2; Fisher College of Business Working Paper No. 2016-03-02. Available at SSRN: https://ssrn.com/abstract=2722784 or http://dx.doi.org/10.2139/ssrn.2722784

Jack Bao

University of Delaware - Department of Finance ( email )

Alfred Lerner College of Business and Economics
Newark, DE 19716
United States

Kewei Hou (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

Shaojun Zhang

The Ohio State University ( email )

830 Fisher Hall
2100 Neil Ave
Columbus, OH
United States

HOME PAGE: http://shaojunzhang.com

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