Term Structure Of Spreads Research Articles

A Structural Approach to Estimate Short-Term and Long-Term Country Default Risk from Market Data: The Case of Argentina 2000/2001

Abstract We apply a structural pricing model to bond market data in order to estimate the default risk for Argentina in 2000/2001. The model explicitly considers short-term and long-term debt service payments and their dependencies by employing compound option theory. In this way, it is possible to take into account both the empirically observed dependency between the term structure of bond spreads and the default risk as well as the finding that the ratio of short-term to long-term debt is of special importance for default risk. The model parameters are estimated using Duan’s (1994) time series-based maximum likelihood approach.

Factor Vector Autoregressive Estimation of Heteroskedastic Persistent and Non Persistent Processes Subject to Structural Breaks: New Insights on the US OIS Spreads Term Structure

In the paper a general framework for large scale modeling of macroeconomic and financial time series is introduced. The proposed approach is characterized by simplicity of implementation, performing well independently of persistence and heteroskedasticity properties, accounting for common deterministic and stochastic factors. Monte Carlo results strongly support the proposed methodology, validating its use also for relatively small cross-sectional and temporal samples. By means of the proposed approach, new insights on US money market dynamics during the subprime and euro area financial crises are achieved. Moreover, three common factors, bearing the interpretation of level, slope and curvature factors, are extracted from the term structure of OIS spreads; we find the latter conveying additional information, relatively to commonly used credit risk measures like the TED or the BAA-AAA corporate spreads, which might be exploited, also within a composite indicator, for the construction of a risk barometer and real-time macroeconomic forecasting.

Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed‐form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in‐depth analysis of probabilities of default and the term structure of credit spreads.

A Joint Analysis of the Term Structure of Credit Default Swap Spreads and the Implied Volatility Surface

AbstractThis study analyzes the co‐movements of the term structure of credit default swap (CDS) spreads and the implied volatility surface by performing a factor decomposition for both dynamics. In our joint analysis we compute the information flow between the credit and volatility factors, examine their contemporaneous interactions, and assess the effectiveness of cross‐hedges. Using options and CDS data for U.S. and European indices, the credit market is found to be the main contributor to overall market innovations. Our methodology is parsimonious and captures the intrinsic relationships between both markets. The empirical study highlights cross‐market linkages during the Global Financial Crisis. Factors with small associated eigenvalues can be of tremendous importance for effective cross‐hedging. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark

On the Relative Pricing of Long‐Maturity Index Options and Collateralized Debt Obligations

ABSTRACTWe investigate a structural model of market and firm‐level dynamics in order to jointly price long‐dated S&P 500 index options and CDO tranches of corporate debt. We identify market dynamics from index option prices and idiosyncratic dynamics from the term structure of credit spreads. We find that all tranches can be well priced out‐of‐sample before the crisis. During the crisis, however, our model can capture senior tranche prices only if we allow for the possibility of a catastrophic jump. Thus, senior tranches are nonredundant assets that provide a unique window into the pricing of catastrophic risk.

Credit risk, valuation and fundamental analysis

This study explores how a firm's credit risk affects accounting based valuation of the firm, of its equity and of its debt. The valuation model integrates fundamental equity and credit analysis and, under appropriate conditions, abides by the value conservation principle even in the presence of credit risk. The term structures of credit spreads on corporate bonds and credit default swaps are linked to equity valuation and to pro-forma financial statements. Calibration of the valuation model to equity and credit market prices is feasible. The model explains how credit risk depresses price to earnings and price to book ratios.

The Term Structure of CDS Spreads and Sovereign Credit Risk

I study the term structure of credit default swap spreads to understand the dynamics of global and country-specific risk factors in explaining the time-variation in sovereign credit risk. The analysis suggests that the shape of the term structure conveys significant information on the relative importance of global and domestic risk. When the spread curve is upward sloping, global shocks are the dominant force underlying changes in the price of sovereign credit risk. Nonetheless, domestic shocks become relatively more important when the term structure is inverted. To draw these conclusions, I develop a recursive preference-based model with long-run risk for credit default swaps. The underlying default process, which modulates expectations about future default probabilities, is modeled to depend both on global macroeconomic uncertainty and country-specific risk. Time-variation in the slope can be explained through the joint dynamics of aggregate and idiosyncratic shocks in connection with investor preferences. Additional supporting evidence of the model-implied results is provided by empirical analysis using a panel of 44 geographically dispersed countries. First, the variation in spreads explained by their first common component decreases during the sovereign debt crisis. Second, country-specific fundamentals explain relatively more spread variation of distressed countries, which are characterized through a downward sloping spread curve. Third, the explanatory power of domestic factors is monotonically increasing with the number of months the term structure was inverted. Overall, these findings support the view that both sources of risk are important, they simply matter at different points in time.

Understanding the Term Structure of Credit Default Swap Spreads

The shape of the term structure of credit default swap (CDS) spreads displays large variations over time and across firms. Consistent with the predictions of structural models of credit risk, we find that the slope of CDS spread term structure increases with firm leverage and volatility, but decreases with the level and the slope of the Treasury yield curve. However, these variables together have rather limited explanatory power for CDS slope and there is a significant common component in the regression residuals. In addition, we find that CDS slope predicts future changes in CDS spreads, even after controlling for the contemporaneous variables that determine changes in CDS spreads according to the structural models. Our results suggest that while structural models are qualitatively useful for understanding the shape of credit term structure, there are missing factors that importantly affect the term structure of CDS spreads.

Common Factors in the Performance of European Corporate Bonds – Evidence Before and after Financial Crisis

This paper examines common risk factors in Euro-denominated corporate bond returns before and after recent financial crisis. Our results suggest that level and slope of interest rate and default spread term structures significantly improve the explanatory power of asset pricing models for the cross-section of corporate bonds. Further, we demonstrate that corporate bonds with maturities between one and three years continue to yield statistically significant abnormal returns even after controlling for the levels and slopes of interest and default spread term structures. The abnormal returns are up to 151 basis points annually for these short term bonds and are thus of considerable economic interest. The sensitivity of corporate bond returns to interest rate level and slope risk is quite stable over time, whereas the sensitivity to level and slope default risk factors changed during the period of recent financial crisis. Our results are robust to GRS-test, calendar seasonality, and use of alternative risk-free benchmarks.

Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

We build a structural model to explain corporate debt maturity dynamics over the business cycle and their implications for the term structure of credit spreads. Longer-term debt helps lower firms' default risks while shorter-term debt reduces investors' exposures to liquidity shocks. The joint variations in default risks and liquidity frictions over the business cycle cause debt maturity to lengthen in economic expansions and shorten in recessions. The model predicts that firms with higher systematic risk exposures will choose longer debt maturity, and that this cross-sectional relation between systematic risk and debt maturity will be stronger when risk premium is high. It also shows that the pro-cyclical maturity dynamics induced by liquidity frictions can signi cantly amplify the impact of aggregate shocks on credit risk, with different effects across the term structure, and that maturity management is especially important in helping high-beta and high-leverage firms reduce the impact of a crisis event that shuts down long-term refinancing. Finally, we provide empirical evidence for the model predictions on both debt maturity and credit spreads.

The Term Structure of CDS Spreads and Sovereign Credit Risk

The Term Structure of CDS Spreads and Sovereign Credit Risk

Dynamic Interactions Between Interest-Rate and Credit Risk: Theory and Evidence on the Credit Default Swap Term Structure*

This paper examines the interaction between default risk and interest-rate risk in determining the term structure of credit default swap spreads at different industry sectors and credit-rating classes. The paper starts with a parsimonious three-factor interest-rate dynamic term structure and projects the credit spread at each industry sector and rating class to these interest-rate factors while also allowing the projection residual dynamics to depend on the level of the interest- rate factors. Estimation shows that credit risk exhibits intricate dynamic interactions with the interest-rate factors.

Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed-form solutions for the market values of the firm's debt and equity. We next assess the magnitude of the spread differential between junior and senior bond yields, which is positively but not linearly related to the total debt level and the riskiness of assets. We finally provide an in-depth analysis of probabilities of default and the term structure of credit spreads.

Investment-Based Corporate Bond Pricing

A standard assumption of structural models of default is that firms' assets evolve exogenously. In this paper, we examine the importance of accounting for investment options in models of credit risk. In the presence of financing and investment frictions, fi rm-level variables that proxy for asset composition are significant determinants of credit spreads beyond leverage and asset volatility, because they capture the systematic risk of firms' assets. Cross-sectional studies of credit spreads that fail to control for the interdependence of leverage and investment decisions are unlikely to be very informative. Such frictions also give rise to a realistic term structure of credit spreads in a production economy.

On the choice of liquidity horizon for incremental risk charges: are the incentives of banks and regulators aligned?

The recent incremental risk to the Basel market risk requires banks to estimate, separately, the default and migration risk of their trading portfolios that are exposed to credit risk. The regulation requires the total regulatory charges for trading books to be computed as the sum of the market risk capital and the incremental risk charge for credit risk. In the calculation of incremental risk charges a key component is the choice of the liquidity horizon for traded credits. In this paper we explore the effect of the liquidity horizon on the incremental risk charge and in particular validate that the framework for assigning liquidity horizons proposed by regulation is consistent with bank's motivation to conserve the regulatory capital requirement. We consider a stylized portfolio of 28 bonds with different ratings and liquidity horizons to evaluate the impact of the choice of the liquidity horizon for a certain rating class of credits. We find that choosing the liquidity horizon for a particular credit there are two important effects that need to be considered. The first effect is the bonds with short liquidity horizons can avoid further downgrading by frequently trading to a bond of the same initial quality. The second effect is the possibility of multiple defaults. Our findings are also supported by empirical result of credit spread term structure. Therefore, the liquidity horizon specification in the incremental risk charge requirement from Basel committee is consistent with the market reality, banks' incentive in capital requirement conservation and consequently alleviates the concerns in IRC model validation.

Equity Options, Credit Default Swaps and Leverage: A Simple Stochastic-Volatility Model for Equity and Credit Derivatives

The aim of this paper is to define a model which allows traders to assess the value of equity and credit derivatives in a unified framework. We propose closed form formulas which traders could use to evaluate equity, equity options and credit default swaps (CDSs) in a consistent way. The model can also be used to solve the inverse problem, that is to extract credit-risk sensitive information from market quotes of equity/credit derivatives. In particular, we wish to estimate the firm’s leverage, as it is perceived by traders. This goal is achieved within a model a la Leland (1994), where stockholders have a perpetual American option to default. After making the case for modeling debt in terms of a single perpetual-bond equivalent issue, we define leverage, show the stochastic nature of equity volatility and derive the term structures of default probabilities and credit spreads by making use of the first-passage time distribution function. Then, we give new formulas for call and put options written on stockholders’ equity. The formulas, which depend on the leverage parameter L and make use of the univariate normal distribution function, are consistent with the volatility skew observed in the equity options market and converge to the Black-Scholes-Merton (BSM) equations for L ? 1. All the Greeks are simple functions of the standard corresponding letters of the BSM model. The paper concludes with an application of the model to the case of Lehman Brothers and General Motors.

Term structure of credit spreads with learning and anticipation effects

In this paper we unify structural and reduced form models, and further extend Duffie and Lando (2001) to consider the relation between credit spreads and investors' information structures. In the first part of the paper, investors' information is incomplete; we show how investors should utilize spot markets information to learning asset process parameters and infer the default barrier through time. In the second part of the paper, investors' information set is enlarged to include future and derivative markets information. By way of conditioning on this extended information set, we show how to incorporate anticipative messages into our original model, which gives us a better estimation of the firm's survival probability. In the numerical simulation, our credit spreads fit very with with empirical results. This fully demonstrates that some components of credit spread can be attributed to learning and anticipation effects.

Force-Fitting CDS Spreads to CDS Index Swaps

CDOs present some of the thorniest valuation problems in derivatives these days. The most widely used approaches are based on the strong assumption that the individual securities in the underlying pool are homogeneous. The most popular portfolios used as underliers are constructed from credit default swaps to replicate standard credit indexes, like CDX.NA.IG, or iTraxx, each of which contains CDS on 125 names. The CDO model assumes they can be treated as if they were identical, but in reality, their spreads in the market can be quite diverse. The result can be an internal discrepancy between the pricing of the CDO tranches and the 125 CDS they are composed of, especially with regard to the term structure of credit spreads. Although O’Kane shows that transactions costs are too large for the apparent arbitrage trades to be profitably implemented, it is still undesirable for model values for closely related instruments to be inconsistent with one another. In this article, O’Kane first gives a detailed description of the pricing conventions in the two markets and explains how differences in the way features like restructuring clauses are treated give rise to different valuations. He then offers a way to harmonize the two by appropriately modifying CDS quotes. <b>TOPICS:</b>Credit default swaps, portfolio construction

The search for relative value in bonds

Comparing asset swap spreads across bonds is a widely used tool for measuring relative value. This approach leads portfolio managers to increase their risk exposure in ways that are not transparent. Credit default swaps are utilized to demonstrate that viewing wide asset swaps as an indicator of relative value is a mirage. The paper documents the empirical regularities in the term structure of credit spreads and spread volatilities that make this result possible. In addition, we present empirical evidence of the imprint made on corporate bond returns by the widespread use of the asset swaps data.

Term Structure of Credit Default Swap Spreads and Cross-Section of Stock Returns

The slope of a firm's term structure of credit default swap (CDS) spreads (five-year spread minus one-year spread) negatively predicts future stock returns. Stocks with low CDS slope on average outperform stocks with high CDS slope by over 1% each month for the next six months. Our result can not be explained by standard risk factors, stock characteristics, default risk measures or changes in CDS spreads. We find that CDS slope positively predicts future changes in CDS spreads, but the information content of CDS slope only slowly gets incorporated into stock price. CDS slope predicts return mainly for stocks facing high arbitrage costs.