The Credit Spread: Risk-Free Rate in the Model

Abstract

This paper proposes a parsimonious credit spread estimation model for valuation of corporate bonds in data-scarce markets. We emphasize the importance of incorporating the risk-free rate directly into credit spread determination. Our model aligns with established literature and demonstrates the ability to capture the observed influence of risk-free rates on credit spreads across economies. We posit that models omitting the risk-free rate component may underestimate credit spreads, particularly impactful in emerging markets with elevated default probabilities and high risk-free rates. Finally, we discuss practical applications of the model, including exchange rate premium calculations, policy analysis, and negative yield spread analysis.