The purpose of this article is to explain the spread between spot rates on corporate and government bonds. We find that the spread can be explained in terms of three elements: (1) compensation for expected default of corporate bonds (2) compensation for state taxes since holders of corporate bonds pay state taxes while holders of government bonds do not, and (3) compensation for the additional systematic risk in corporate bond returns relative to government bond returns. The systematic nature of corporate bond return is shown by relating that part of the spread which is not due to expected default or taxes to a set of variables which have been shown to effect risk premiums in stock markets Empirical estimates of the size of each of these three components are provided in the paper. We stress the tax effects because it has been ignored in all previous studies of corporate bonds. 1

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1 Wewould like to thank Dan Chen, Louis Gagnon and participants in seminars at the Kansas City Federal Reserve and the Credit Risk Conference, Toronto, for their comments. We are especially grateful to two referees for their detailed suggestions on improving the paper's presentation and content. Although it will not evidence runtime errors, the program code presented in this paper is intended only as pseudo-code. Usage of the code is permitted with proper attribution, at the user's risk. This paper develops a framework for modelling risky debt and valuing credit derivatives that is exible and simple to implement, and that is, to the maximum extent possible, based on observables. Our approach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable debt. We do not follow the procedure of implying out the behavior of spreads from assumptions concerning the default process, instead working directly with the evolution of spreads. We show that risk-neutral drifts in the resulting model possess a recursive representation that particularly facilitates implementation and makes it possible to handle path-dependence and early exercise features without di culty. The framework permits embedding a variety of speci cations for default; we present an empirical example of a default structure which provides promising calibration results. 1

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may be undertaken at the user’s risk. We would like to thank an anonymous referee whose suggestions have improved the exposition in the paper. 2 The paper was written while Viral V. Acharya was a doctoral student at the Stern School of Business, New York University. Pricing Credit Derivatives with Rating Transitions We develop a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach is based on expanding the Heath-Jarrow-Morton (1990) term-structure model and its extension, the Das-Sundaram (2000) model to allow for defaultable debt with rating transitions. The framework has two salient features, comprising extensions over the earlier work: (i) it employs a rating transition matrix as the driver for the default process, and (ii) the entire set of rating categories is calibrated jointly, allowing, with minimal assumptions, arbitrage-free restrictions across rating classes, as a bond migrates amongst them. We provide an illustration of the approach by applying it to price credit sensitive notes that have coupon payments that are linked to the rating of the underlying credit. 1

We compare Longstaff and Schwartz (1995) (the LS model) and Merton (1974) using Eurodollar data. We show that both models are restrictive for money market securities due to modelling arrival time of default as a predictable process, which implies that credit term structure has to start from zero. The Merton model, on the other hand, does have some advantages over the LS model. For a currently solvent firm, the Merton model can generate a hump-shaped credit term structure that converges to a positive constant as time to maturity goes to infinity. In contrast, the LS model generates a hump-shaped credit structure that converges to zero. We estimate and test both models using observed Eurodollar credit term structures in 1992. We find that the LS model is more difficult to estimate due to large number of parameters, complex model structures and intensive calculation requirements. We also find that N-shaped credit term structures prevail in the Eurodollar market during 1992. N-shaped credi...

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In recent years there have been a number of papers examining the pricing of corporate debt. These papers have varied from theoretical analysis of the pricing of risky debt using option pricing theory, to a simple reporting of the default experience of various categories of risky debt. The vast majority of the articles dealing with corporate spreads have examined yield differentials of interestpaying