Dynamics Of Credit Spreads Research Articles

The Dynamics of the Credit Spread and Monetary Policy

This paper empirically examines the aggregate determinants of the credit spread and the influence of monetary policy shocks on its dynamics in Korea. Using the innovations accounting technique from an estimated vector autoregression (VAR) model, we provide a set of interesting results on the short run and the medium run determinants of the credit spread and its dynamics. The key findings are that (i) the default risk premium is the major driving force of the credit spread dynamics for low grade bonds, and (ii) monetary policy is a significant driving force of the medium term dynamics of the credit spread.

Leverage Choice and Credit Spread Dynamics When Managers Risk Shift

We develop a structural model of the leverage choices of risk-averse managers who are compensated with cash and stock. We further characterize credit spread dynamics over the life of the debt. Managers optimally balance the tax benefits of debt with the utility cost that results from their ex-post asset substitution choices. Our model predicts the existence of a U-shaped relationship between the cash component of pay and leverage levels: when cash compensation is low, safe debt with a high face value is issued and when cash compensation is high, risky debt with a high face value is issued. At moderate levels of the cash-to-stock value ratio low leverage is chosen but credit spreads can be significant and again relate to compensation terms. The model illustrates the quantitative importance of including agency costs in the tradeoff theory of capital structure

Quadruple-Threshold Credit Risk Modeling: Implications for Corporate Financial Risk Management

This paper develops a new modeling technique for credit risk by applying the self-exciting threshold autore- gressive (SETAR) model with quadruple thresholds to the credit spread in Japan. Using this technique, we successfully reveal that the credit spread dynamics in Japan are divided into five risk levels (categories) by four threshold values. Our investigations also clarify that the credit spread in Japan is highly persistent when the spread is in the second-lowest credit risk level, and that it moves faster without showing persistent dynamics when it is in the middle- and higher-credit risk levels. Furthermore, the levels of the boundary values that specify the lowest-and highest-credit risk regimes can be inter- preted as a type of value-at-risk measure; it is considered to be an extreme case when the spread is in the lowest- or high- est-credit risk levels suggested by our model.

Detecting Regime Shifts in Credit Spreads

Using an innovative random regime shift detection methodology, we identify and confirm two distinct regime types in the dynamics of credit spreads: a level regime and a volatility regime. The level regime is long lived and shown to be linked to Federal Reserve policy and credit market conditions, whereas the volatility regime is short lived and, apart from recessionary periods, detected during major financial crises. Our methodology provides an independent way of supporting structural equilibrium models and points toward monetary and credit supply effects to account for the persistence of credit spreads and their predictive power over the business cycle.

The credit spread dynamics of Latin American euro issues in international bond markets

This paper investigates two important relationships using the sovereign issues made by major Latin American economies in the international bond market: the determinants of credit spread changes using variables derived from structural and macroeconomic theory and the impact of a default episode on the underlying equilibrium dynamics. We find four significant determinants of credit spread changes: an asset and interest rate factor—consistent with structural models of credit spread pricing; the exchange rate—consistent with macroeconomic determinants and the slope of the yield curve—consistent with a business cycle effect. Also, an intra-regional analysis of sovereign yields reveals a shift in the long-run equilibrium dynamics around the Argentine default on the 23 December 2001.

The Dynamics of Credit Spreads on Latin American Eurobonds

We investigate two important relationships using the most liquid and option-free, sovereign Eurobond issues of major Latin American economies: the determinants of credit spread changes using variables derived from structural and macroeconomic theory; and the impact of a default episode on the underlying equilibrium dynamics of credit spreads. We find four significant determinants that drive the credit spreads in these markets: an asset and interest rate factor - consistent with structural models of credit spread pricing; exchange rate factors - consistent with macroeconomic determinants and the slope of the yield curve - consistent with a business cycle effect. The statistical significance of the exchange rate factor, which also proxies for country risk and the slope variable may be attributed to the sovereign risk premium demanded by investors before buying these bonds. We also find significant autoregressive moving average (ARMA) effects when modelling spread returns indicating a degree of inertia associated with the pricing of sovereign credit spreads in these emerging markets. Finally, an intra-regional analysis of sovereign yields reveals a shift in the long run equilibrium dynamics around the Argentine default on the 23rd of December 2001. Specifically there was a decline in the importance of the cross border cointegration relationship: intramarket relationships have become more important than intermarket (bivariate or pairwise) relationships.

The Joint Behavior of Credit Spreads, Stock Options and Equity Returns When Investors Disagree

We study how investors' disagreement on firm's future cash flows affect the joint behavior of credit spreads, option implied volatilities, and stock returns. We find several important features that can help to explain the dynamics of credit spreads. First, beliefs heterogeneity impacts on the pricing kernel in a way that supports more realistic corporate credit spreads. Second, it induces a positive co--movement between credit spreads, stock returns volatility and the option implied volatility. Third, we obtain an endogenous interaction between option implied volatility skew and leverage, which offers a structural explanation for the inverted volatility skew of some single-stock options. Fourth, the model helps to rationalize both the negative (positive) delta of some call (put) options and the positive link between credit spreads and some individual stock prices. We test the main model predictions in a set of panel regressions, by matching four data sets of firm--specific information on professional earning forecasts, balance-sheet data, corporate bond spreads, stock returns and individual option prices. We find that disagreement among investors impacts on credit spreads, the volatility smile of individual options and stock returns in a way that is consistent with our model, even after controlling for other control variables. Moreover, it has explanatory power for the violations of arbitrage--free restrictions of single--factor models in the data, which are found to have a similar leverage-dependent structure as in our model.

The Dynamics of Credit Spreads and Ratings Migrations

AbstractThere is a large and growing literature on how to model the dynamics of the default-free term structure to fit the observed historical data. Much less is known about how best to model the dynamics of defaultable yield curves. This paper develops a class of defaultable term structure models that is tractable enough to be empirically implemented and flexible enough to capture some important behaviors of the credit spreads in the data. We compare two non-nested models within this class using a Bayesian estimation technique, which helps to solve the problem of latent state variables. The Bayesian approach also enables us to test the two non-nested models on the basis of the Bayes factor. The results strongly suggest that models with constant transition probabilities will not be able to fit the observed dynamics of inter-rating spreads.

DEFAULTABLE LÉVY LIBOR RATES AND CREDIT DERIVATIVES

We introduce the intensity-based defaultable Lévy Libor model, which generalizes the default-free Lévy Libor model introduced by Eberlein and Özkan in [The defaultable Lévy term structure: Ratings and restructuring, Mathematical Finance13(2) (2003) 277–300], and the intensity-based defaultable model presented by Bielecki and Rutkowski in [Credit Risk: Modeling, Valuation and Hedging, Springer Finance (Springer-Verlag, 2002)] by embedding it in the defaultable HJM framework introduced by Eberlein and Özkan in [The defaultable Lévy term structure: Ratings and restructuring, Mathematical Finance13(2) (2003) 277–300]. We also derive some additional results for defaultable HJM models such as the dynamics of credit spreads. We then go on and model the default-free Libor rates and credit spreads as the primal variable and derive the dynamics of the defaultable Libor rates under the defaultable forward measure. Finally, we derive an explicit formula for options on credit default swaps, using an idea introduced by Raible in [Lévy Processes in finance: Theory, numerics and empirical facts, PhD thesis, University of Freiburg i. Brsg. (2000)].

Leverage Choice and Credit Spread Dynamics When Managers Risk Shift

We develop a structural model of the leverage choices of risk-averse managers who are compensated with cash and stock. We further characterize credit spread dynamics over the life of the debt. Managers optimally balance the tax beneflts of debt with the utility cost that results from their ex-post asset substitution choices. Our model predicts the existence of a U-shaped relationship between the cash component of pay and leverage levels: when cash compensation is low, safe debt with a high face value is issued and when cash compensation is high, risky debt with a high face value is issued. At moderate levels of the cash-to-stock value ratio low leverage is chosen but credit spreads can be signiflcant and again relate to compensation terms. The model illustrates the quantitative importance of including agency costs in the tradeofi theory of capital structure.

The Lévy Libor model with default risk

In this paper we present a model for the dynamic evolution of the term structure of default-free and defaultable interest rates. The model is set in the Libor market model framework but in contrast to the classical diffusion-driven setup, its dynamics are driven by a time-inhomogeneous Levy process which allows us to better capture the real-world dynamics of credit spreads. We present necessary and sufficient conditions for absence of arbitrage in the dynamics of the spreads, and provide pricing formulae for defaultable bonds, credit default swaps and options on credit default swaps in this setup.

Modelling Credit Spread: A Fractional Integration Approach

We investigate the long memory properties of Treasury and corporate bond yields, spreads over Treasury and spreads between corporate yields, by considering a dynamic model of credit spreads consistent with recent econometric developments in modelling long range dependence in time series. We provide clear empirical evidence suggesting that applied analyses on credit spreads cannot be carried out within the classical I(0) vs I(1) framework, i.e. by testing for stationarity vs nonstationarity of spreads only. The empirical findings reported in this paper have strong implications for modelling credit spread dynamics and call for a reconsideration of the theoretical framework used to model the dynamics of credit spreads so far.

Default Correlation in Reduced-Form Models

Reduced-form models have proven to be a useful tool for analyzing the dynamics of credit spreads. However, some have recently questioned their ability to match the level of empirical default correlation. The key concern appears to be the assumption that defaults are independent conditional on the state variables driving the default intensity. In this paper, I use a thought experiment as well as numerical examples calibrated to recent studies to show that the model-implied default correlation can be quite sensitive to the common factor structure imposed on the default intensity. Therefore, the inability of reduced-form models to generate sufficient default correlation has more to do with a restrictive common factor structure than the assumption of conditional independence.

DEFAULT RISK AND DIVERSIFICATION: THEORY AND EMPIRICAL IMPLICATIONS

Recent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity's diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of “diversifiable default risk.” The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage‐backed securities.

Modeling the Dynamics of Credit Spreads with Stochastic Volatility

This paper investigates a two-factor affine model for the credit spreads on corporate bonds. The first factor can be interpreted as the level of the spread and the second factor is the volatility of the spread. The riskless interest rate is modeled using a standard two-factor affine model, thus leading to a four-factor model for corporate yields. This approach allows us to model the volatility of corporate credit spreads as stochastic, and also allows us to capture higher moments of credit spreads. We use an extended Kalman filter approach to estimate our model on corporate bond prices for 108 firms. The model is found to be successful at fitting actual corporate bond credit spreads, resulting in a significantly lower root mean square error than a standard alternative model both in sample and out of sample. In addition, key properties of actual credit spreads such as the stochastic volatility of the credit spreads and the positive skewness of the credit spread distribution are better captured by the model.

Modeling the Dynamics of Credit Spreads with Stochastic Volatility

This paper investigates a two-factor affine model for the credit spreads on corporate bonds. The first factor can be interpreted as the level of the spread, and the second factor is the volatility of the spread. The riskless interest rate is modeled using a standard two-factor affine model, thus leading to a four-factor model for corporate yields. This approach allows us to model the volatility of corporate credit spreads as stochastic, and also allows us to capture higher moments of credit spreads. We use an extended Kalman filter approach to estimate our model on corporate bond prices for 108 firms. The model is found to be successful at fitting actual corporate bond credit spreads, resulting in a significantly lower root mean square error (RMSE) than a standard alternative model in both in-sample and out-of-sample analyses. In addition, key properties of actual credit spreads are better captured by the model.

Dynamics of Credit Spreads

This article uses a particular non-parametric approach to examine the conditional drift and variance of credit spreads. The data include Moody9s Aaa and Bbb seasoned bond index yields for the period February 1977 through May 2001. The results show that the drift function is linear and mean-reverting for Aaa index spreads, but Bbb spreads show a strong non-linearity in the drift function. Around its mean, the drift of Bbb spreads is essentially zero, behaving like a random walk, but it mean-reverts strongly when far away from the mean. For pricing and hedging applications, the affine class of parametric diffusion specifications is therefore likely to work well for Aaa spreads, while a non-linear specification is preferable for Bbb spreads.

Default Risk and Diversification: Theory and Empirical Implications

Recent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity's diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of ``diversifiable default risk.'' The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage-backed securities.