Abstract
While much attention has been paid to the level of credit spreads, very little research has focused on the volatility dynamics implied by common models of credit risk. This article demonstrates that the structural framework for modeling credit risk implies that credit spread volatility is bounded by asset volatility, and derives a simple expression for the process followed by default probabilities. Volatility declines with time to maturity and the risk-free rate. Default probabilities exhibit a theoretical smoothness that is not an artifact of the data. Structural models also achieve maximal volatility only at very low asset values, and below the face value of the debt, and there is also limited evidence that higher-rated debt generates higher heteroscedasticity than lower-rated debt.
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