Douglas S. Rolph

City University of Hong Kong

Telephone:   (852) 2788-9492

Email:            drolph@cityu.edu.hk

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Working Papers

1.  Default risk, equity returns and the value of limited liability protection

 This paper examines the impact of limited liability on equity prices and expected returns. I develop an equity pricing model that links investors’ preference for downside loss protection to the limited liability feature of equity. The hedging value of limited liability increases with the systematic risk of firms’ assets. For sufficiently high levels of systematic risk, expected equity returns decline as leverage increases. Empirically, I find a strong negative relation between average returns and financial leverage for firms with high equity covariance risk. These findings suggest that the limited liability feature of equity plays an important role in driving the negative relation between average returns and default risk.

    Keywords: Equity returns, skewness, limited liability, default, firm characteristics, idiosyncratic risk

    JEL Catagories: G12, G13, G33, C19

2.  Co-skewness, Firm-Level Equity Returns and Financial Leverage

This paper examines the relation between co-skewness risk and average equity returns. Numerous studies reject that portfolio covariance and co-skewness risk explain average returns, while estimated co-skewness risk premiums vary greatly among studies. I provided new insights into the existence of co-skewness risk and its determinants in firm-level equity returns. Using a large cross section of individual equity returns, I find a strong negative relation between co-skewness risk and average returns that varies with financial leverage. The results indicate that the skewness induced by the limited liability feature of equity plays an important role in explaining the cross section of equity returns.

    Keywords: Quadratic pricing kernel, skewness, co-skewness, leverage, cross-sectional regression, minimum distance estimators

    JEL Catagories: G12, G33, C21, C22

3.  Interest Rates and Credit Spread Dynamics (With Robert Neal, Indiana University)

    This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. These results imply a dynamic process for credit spreads that is not captured in existing models for pricing corporate bonds or measuring their interest rate sensitivity.

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Updated February 23, 2009