Using dealer’s quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross-correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply0 demand shocks that are independent of both credit-risk factors and standard proxies for liquidity.

This paper investigates a two-factor affine model for the credit spreads on corporate bonds. The Þrst 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 Þlter approach to estimate our model on corporate bond prices for 108 Þrms. The model is found to be successful at Þtting actual corporate bond credit spreads, resulting in a signiÞcantly 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.

This paper explores empirically the usefulness of credit default swap (CDS) prices as market indicators. The sample of reference entities consists of large, internationally active German banks and the observation period covers three years. By analysing the explanatory power of three risk sources, idiosyncratic credit risk, systematic credit risk, and liquidity risk, we gain important insights for modelling the dynamics of CDS spreads. The impact of systematic risk, for example, has two components, one related to the overall state of the economy and the other to a banking– sector specific component. Contrary to previous research for corporate bonds we find that CDS premia of German banks rise with an increasing risk–free interest rate, which may be explained by its impact on term transformation risk. We compare default probabilities, inferred from a tractable reduced form model for CDS spreads, with expected default frequencies from the Moody’s KMV model. The results provide empirical support to the hypothesis that structural models based on equity market prices may be less informative than reduced–form models of CDS spreads, especially for banks with major investment banking activities, because the leverage looses explanatory power. Although the CDS market appears to have matured in the observation period, in certain periods premiums for liquidity risk can substantially increase which limits their value as market indicators. We conclude that equity prices and CDS premia should be considered together to fully exploit the information content of both market indicators and to mitigate their respective drawbacks.

Dynamic equilibrium correction modelling of yen Eurobond credit spreads

This paper explores the transmission of credit conditions into the real economy. Specifically, I examine the forecasting power of the term structure of credit spreads for future GDP growth. I find that the whole term structure of credit spreads has predictive power, even though the term structure of Treasury yields has none. Using a parsimonious macro-finance term structure model that captures the joint dynamics of GDP, inflation, Treasury yields and credit spreads, I decompose the spreads and identify what drives the relationship between credit spreads and the real economy. I show that there is a pure credit component orthogonal to macroeconomic information that accounts for a large part of the forecasting power of credit spreads. The macro factors themselves also contribute to the predictive power, especially for long maturity spreads. Taken together, credit and macro factors capture virtually all predictability inherent in the actual spreads, while additional factors affecting Treasury yields and credit spreads are irrelevant. The credit factor is highly correlated with the index of tighter loan standards, thus lending support to the existence of a transmission channel from borrowing conditions to the economy.

Based on the works of Brockman and Turtle (2003) and Giesecke (2004), we proposed in this study a hybrid barrier option model with corporate capital gains tax which is free of problems within the structural model in explaining observed credit spreads. Our approach does not predict credit spreads that are too low for investment grade corporate bonds; neither does it predict credit spreads that are too high for high yield issues. Our empirical analysis supports the validity of this model over the structural model. When credit spreads are quoted abnormally higher than expected, they tend to persist. Otherwise the reversion to long term equilibrium is significant and prompt. This asymmetric pricing behavior is validated with a method introduced by Enders and Granger (1998) and Enders and Siklos (2001). The pricing asymmetry could not have been produced by a structural model employing only standard option. But it is consistent with a hybrid barrier option model. Our model characterizes the valuation of debt under financial stress and the asymmetric price pattern better than both the classical structural and the standard barrier option approaches. This study provides helpful implications especially for the medium and high yield issues in pricing as well as portfolio diversification.

This study specifies an equilibrium correction model of the credit spreads on quality Japanese yen Eurobonds. In an important paper by Longstaff and Schwartz (1995) the authors derive a closed form solution of the arbitrage-free value on risky debt in continuous time. However, in discrete time real world data series it is common that many non-stationary economic and financial time series are cointegrated. Nevertheless, until now there is no theory for continuous time cointegration. In addition, the existence of cointegration in prices leads to incomplete markets so that the arbitrage-free valuation should not apply. Instead one must rely on equilibrium pricing, where the markets clear in the equilibrium via a potentially complicated adjusting process. In this paper the important factors driving the credit spreads are introduced into the equilibrium relation and the adjusting process are investigated. The results indicate that the corporate bond yields are cointegrated with the otherwise equivalent Japanese Government Bond (JGB) yields, with the spread defining the cointegration relation. Furthermore, the results indicate that the equilibrium correction term is highly statistically significant in modelling spread changes. The other important factor is the risk-free interest rate with the negative sign as predicted