Credit Spreads with Jump Risks and Stationary Leverage Ratio

Abstract

Recent structural models have utilized new factors to enhance their exploratory power over credit spreads. Some studies have shown that jump risks allow us to obtain credit spreads that are more realistic. However, according to the empirical studies on capital structure, another factor that affects credit spreads is the stationary leverage ratio of a firm. The present paper develops a simple structural model and incorporates both jump risks and the stationary leverage ratio to explain credit spreads. In comparison to the existing jump-diffusion structural model, this model generates a larger credit spread, which is more consistent with observed credit spreads, especially for investment-grade bonds. This paper also shows that jump frequency and size may be significant factors determining credit spreads for firms.