Essays on Credit Risk

This dissertation covers the issues related to credit risk that stem from the recent financial crisis and that are concerned by investors, financial intermediaries, and governments. The results of the research have important implications for asset managers, such as using the information from the credit risk market to rebalance stock portfolios, and for policy makers in regulating or bailing out banks. The first paper, Hidden in the factors? The effect of credit risk on the cross-section of equity returns, disentangles the “distress puzzle” or the opposite, i.e. the existence of a positive cross-sectional relationship between credit risk and stock returns, as well as investigates whether market β, size, value, and momentum effects are attributed to a positive credit risk effect. The second paper, Banks' credit portfolio choice and risk-based capital regulation, studies banks' risk taking in relation to credit risk. I regard a bank as its assets' manager, develop a model of portfolio allocation among assets with different levels of credit risk, and examine the impact of risk-based capital regulation on banks' asset risk. The third paper, TARP and market discipline: Evidence on the moral hazard effects of bank recapitalizations (with Jens Forssbæck), examines the moral hazard effect of government bailout. Specifically, we examine the possible moral hazard effect of the U.S. Troubled Asset Relief Program (TARP) by assessing its impact on the extent of market discipline exerted by uninsured debt-holders on participating and non-participating bank holding companies, and the impact of crisis on the market discipline