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

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...

The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. THE PURPOSE OF THIS ARTICLE is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds ~spreads!, and, in particular, to examine whether there is a risk premium in corporate bond spreads and, if so, why it exists. Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons: 1. Expected default loss—some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium—interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium—The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable. The only controversial part of the above analyses is the third point. Some authors in their analyses assume that the risk premium is zero in the corporate bond market. 1

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Currency mismatches in corporate balance sheets have been singled out as an important factor underlying the severity of recent financial crises. We propose several structural models for measuring default risk for firms with currency mismatches in their asset/liability structure. The proposed models can be adapted to different exchange rate regimes, are analytically tractable, and can be estimated using available equity price and balance sheet data. The paper provides a detailed explanation on how to calibrate the models and discusses two applications to financial surveillance: the measurement of systematic risk in the corporate sector and the estimation of prudential leverage ratios consistent with regulatory capital ratios in the banking sector.

As is well known, most models of credit risk have failed to measure the credit risks in the context of the global financial crisis. In this context, financial industry representatives, regulators and academics worldwide have given new impetus to efforts to improve credit risk modeling for countries, corporations, financial institutions, and financial instruments. The paper summarizes some of the recent advances in this regard. It considers modifications of structural models, including of the classical Merton model, and efforts to reconcile the structural and the reduced-form models. It also discusses the reassessment of the default correlations using copulas, the pricing of credit index options, and the determination of the prices of distressed debt and estimation of recovery values.

in the United States by

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