Modelling credit spreads on yen Eurobonds within an equilibrium correction framework

Abstract

This study develops an equilibrium correction model (ECM) of the credit spreads on quality Japanese yen Eurobonds based on the Longstaff and Schwartz (1995) continuous time, closed form solution of the arbitrage-free value on risky debt. The solution predicts testable relationships between the credit spread and several important factors involved, including the risk-free interest rate, firm asset volatility, and the firm asset return correlation with changes in the risk-free rate. In the frictionless continuous time approach a key assumption is that the markets adjust without delays to the new equilibrium. In reality, however, adjustments take time, such that the markets may be temporally out of the equilibrium. The results of this study show that unlike other findings from the USA, Japanese spreads are stationary. Accordingly, an implied equilibrium correction procedure is incorporated into the modelling process. While traditional theories of credit-spread behaviour predict that changes in the risk free i...