A Dynamic Model for Emerging Debt Markets: The Case of Hong Kong Corporate Credit Risk

Abstract

Following the rationale of the KMV model, this study builds an empirical model to price corporate credit risk for listed corporations in Hong Kong. To mitigate the bias from accounting data, the model totally relies on market-based information, such as equity value, stock market index, implied volatility of market index, riskfree rate and maturity. This fits in the reality of emerging credit markets that there is no credit mortality data, limited external credit ratings and limited data on bond yields. We find some weak evidence to support the model. Both the equity value and the stock market index have significantly negative effects on credit spreads, while the implied volatility of the market index, which measures the economic risk, shows significantly positive effect. The model explains more than 20% of the raw yield spreads. When extreme cases are removed, its explanatory power jumps to more than 50%. Observed and predicted credit spreads are slightly cointegrated. It is obvious that the model is not a complete solution but it successfully helps estimate the credit spreads and corporate credit risk of all listed corporations in Hong Kong. This solution can also be applicable to other emerging credit markets.