An Empirical Investigation of the Short-Term Relationship between Interest Rate Risk and Credit Risk

Abstract

Empirical results from several studies indicate that changes in interest rates and changes in credit spreads are negatively related in the short run. These findings are further investigated by examining the dependence structure between interest rate and credit risk factor changes that are computed from sovereign and corporate bond indices. Several copulas (Gaussian, Student t, BB1, and Frank copula) are calibrated and their goodness-of-fit is compared. No clear pattern of the dependence structure can be observed as it varies substantially with the duration and - concerning the credit risk factor changes - the rating of the obligors. The Student t copula's fit in terms of the AIC goodness-of-fit measure is superior to that of all other copulas. The null hypothesis of a specific copula being the true copula can be rejected for the Student t copula in the least cases. Additionally employing a likelihood-ratio test, the null hypothesis of a Gaussian copula can be rejected in favour of a Student t copula. The Gaussian copula seems to underestimate the probability of joint strong risk factor changes, while the Student t copula seems to overestimate it.