Dynamic Equilibrium Correction Modelling of Credit Spreads. The Case of Yen Eurobonds

Abstract

This study specifies an equilibrium correction model of the credit spreads on quality Japanese yen Eurobonds. In an important paper Longstaff and Schwartz (1995) derive a closed form solution of the arbitrage-free value on risky debt in continuous time. However, in discrete time real world data series it is common that many economic and financial nonstationary time series are cointegrated. Nevertheless, until now there is no theory for continuous time cointegration. In addition the existence of cointegration leads to incomplete markets so that the arbitrage-free valuation should not apply. Instead, one must rely on equilibrium pricing, where the markets clear in the equilibrium via a potentially complicated adjusting process. In this paper the important factors driving the credit spreads are introduced into the equilibrium relation and the adjusting process are investigated. The empirical results indicate that the corporate bond yields are cointegrated with the otherwise equivalent Japanese Government Bond (JGB) yields, with the spread defining the cointegration relation. Furthermore, the results indicate that the equilibrium correction term is highly statistically significant in modelling spread changes. The other important factor is the risk-free interest rate with the negative sign as predicted by the Longstaff and Schwartz (1995). On the other hand there is little evidence of the contribution of the asset return to the spread behaviour. The estimated coefficient of the equilibrium correction term indicates that the adjustment process is fairly slow, which indicates that the clearing process in the markets takes time.