The magnitude and Cyclical Behavior of Financial Market Frictions



Since the BGG model abstracts from various details of financial market behavior,
our estimation procedure incorporates time-specific industry and ratings dummies:
where RATING
it-1 denotes the set of dummies associated with bond portfolio credit
ratings at the end of period
t - 1, and INDUSTRYit denotes the set of industry
dummies; the coefficients on these dummies are allowed to vary over time.
20 The
stochastic disturbance
cit is assumed to have zero mean and to be independent across
firms, but may exhibit time-varying heteroskedasticity; that is, E[
cit] = 0, E[c2t] = ν2t,
and E[
citCjt] = 0, for all i = j.

Rb


Rb


R it


R it


= RATING it-1 + INDUSTRY it + ett,


(12)


The rating dummies are included to control for liquidity factors that arise from the
fact that certain corporate bonds trade rather infrequently, implying a relatively thin
secondary markets for some securities.
21 In such a case, a credit spread will include
a premium to compensate investors for the risk of having to sell or hedge a position
in an illiquid market. As shown by Delianedis and Geske (2001), this liquidity risk is
correlated with default risk and accounts for a significant portion of observed credit
spreads. Controlling for industry differences is potentially important because our
dataset, though rich in the cross-sectional dimension, spans a single business cycle
dominated by the bursting of the high-tech bubble.

Following this approach, the residual vector (c 11,... cntt) can be computed for any
given value of
μ. Thus, for each time period, we start with an initial guess for this
parameter, and then utilize a standard optimization algorithm to obtain the NLLS
estimator
μt that minimizes the sum of squared residuals.22

20Credit rating indicators are based on the average of the S&P ratings of the firm’s outstanding
bond issues, weighted by the market value of bonds. The resulting portfolio credit ratings were
condensed into nine categories: AAA, AA, A, BBB, BB, B, CCC, CC, and C. Industry effects are
based on the 3-digit North American Industry Classification System (NAICS).

21See Warga (1991) for a discussion of problems associated with high-frequency corporate bond
prices and the use of “grid-based” pricing.

22For each time period, we utilized an extensive grid of initial guesses to ensure that the NLLS
estimator reached the global minimum of the objective function.

22



More intriguing information

1. A Dynamic Model of Conflict and Cooperation
2. Foreword: Special Issue on Invasive Species
3. The technological mediation of mathematics and its learning
4. Literary criticism as such can perhaps be called the art of rereading.
5. A Duality Approach to Testing the Economic Behaviour of Dairy-Marketing Co-operatives: The Case of Ireland
6. Industrial Employment Growth in Spanish Regions - the Role Played by Size, Innovation, and Spatial Aspects
7. A Review of Kuhnian and Lakatosian “Explanations” in Economics
8. The name is absent
9. Job quality and labour market performance
10. The name is absent
11. The Value of Cultural Heritage Sites in Armenia: Evidence From a Travel Cost Method Study
12. THE USE OF EXTRANEOUS INFORMATION IN THE DEVELOPMENT OF A POLICY SIMULATION MODEL
13. Disentangling the Sources of Pro-social Behavior in the Workplace: A Field Experiment
14. Experimental Evidence of Risk Aversion in Consumer Markets: The Case of Beef Tenderness
15. The name is absent
16. The name is absent
17. The name is absent
18. The name is absent
19. The name is absent
20. Convergence in TFP among Italian Regions - Panel Unit Roots with Heterogeneity and Cross Sectional Dependence