Essays in financial economics and credit risk

This dissertation investigates the determinants of credit risk and its effects on asset prices. It considers risky bond prices and default probabilities, both at the sovereign country and individual firm levels. It also considers equity pricing of distressed stocks. First, it presents a model of sovereign debt in which macroeconomic fundamentals drive default and bond prices: It considers empirical determinants of yield spreads and default. Next, it investigates the determinants of failure and the pricing of distressed stock at the firm level. The analysis then turns to the effect of news about volatility on bond prices. Finally, the dissertation considers credit risk when expected returns are time varying. Both at the sovereign country as well as at the individual firm levels, volatility plays a central role in determining the probability of a credit event and bond prices. For sovereign debt, the volatility of terms of trade explains a substantial fraction especially of the cross country variation in yield spreads. For individual firms, volatility is one of the most important predictors of bankruptcy and failure; its importance in fact increases with the horizon at which failure is predicted. Also, using corporate bond transaction prices, it is possible to predict future volatility. In addition, time varying expected returns and mean reversion have important effects on default probabilities.