Abstract

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

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