We use the information in credit default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads. We find that the majority of the corporate spread is due to default risk. This result holds for all rating categories and is robust to the definition of the riskless curve. We also find that the nondefault component is time varying and strongly related to measures of bond-specific illiquidity as well as to macroeconomic measures of bond market liquidity.

/pdf/corporate-yield-spreads-default-risk-or-liquidity-new-1oqrwguyth.pdf

Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market

Enclosed is a copy of the Board of Governors’ Semiannual Agenda of Regulations for the period August 1, 1980 through February 1, 1981. The Semiannual Agenda provides you with information on those regulatory matters that the Board now has under consideration or anticipates considering over the next six months, and is divided into three parts: (1) regulatory matters that the Board had considered during the previous six months on which final action has been taken; (2) regulatory matters that have been proposed for public comment and that require further Board consideration; and (3) regulatory matters that the Board may consider over the next six months.

Federal Reserve Bank of New Yorkの制定せる財務諸表様式について

This paper studies the problem of default correlation. We first introduce a random variable called "time-until-default" to denote the survival time of each defaultable entity or financial instrument, and define the default correlation between two credit risks as the correlation coefficient between their survival times. Then we argue why a copula function approach should be used to specify the joint distribution of survival times after marginal distributions of survival times are derived from market information, such as risky bond prices or asset swap spreads. The definition and some basic properties of copula functions are given. We show that the current CreditMetrics approach to default correlation through asset correlation is equivalent to using a normal copula function. Finally, we give some numerical examples to illustrate the use of copula functions in the valuation of some credit derivatives, such as credit default swaps and first-to-default contracts.

On Default Correlation: A Copula Function Approach

This article studies the problem of default correlation. It introduces a random variable called “time-until-default” to denote the survival time of each defaultable entity or financial instrument, and defines the default correlation between two credit risks as the correlation coefficient between their survival times. The author explains why a copula function approach should be used to specify the joint distribution of survival times after marginal distributions of survival times are derived from market information, such as risky bond prices or asset swap spreads. He shows that the current approach to default correlation through asset correlation is equivalent to using a normal copula function. Numerical examples illustrate the use of copula functions in the valuation of some credit derivatives, such as credit default swaps and first-to-default contracts.

/pdf/on-default-correlation-a-copula-function-approach-3wexvt5evk.pdf

We show that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturities, and that it accounts for a much higher fraction of yield spreads for high-yield bonds This conclusion is shown to be robust across a wide class of structural models We obtain such results by calibrating each of the models to be consistent with data on the historical default loss experience and equity risk premia, and demonstrating that different models predict similar credit risk premia under empirically reasonable parameter choices

http://dse.univr.it/safe/Workshops/PhD/2004/huang_huang.pdf

How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk?

This paper analyzes the components of corporate credit spreads. The analysis is based on a structural model that can offer a framework to understand the decomposition. The paper contends that default risk may correctly represent only a small portion of corporate credit spreads. This idea stems both from empirical evidence and from the following theoretical assumptions underlying contingent claim models of default: that markets for corporate stocks and bonds are (i) perfect, (ii) complete, and (iii) trading takes place continuously. Thus, in these models there are no transaction or bankruptcy costs, no tax effects, no liquidity effects, no jump effects reflecting market incompleteness, and no market risk factors effecting the pricing of corporate stocks or bonds. The paper starts with the use of a modified version of the Black-Scholes-Merton diffusion based option approach. We estimate corporate default spreads as simply a component of corporate credit spreads using data from November 1991 to December 1998, which includes the Asian Crisis in the Fall, 1998. First we measure the difference between the observed corporate credit spreads and option based estimates of default spreads. We define this difference as the residual spread. We show that for AAA (BBB) firms only a small percentage, 5% (22%), of the credit spread can be attributed to default risk. We show that recovery risk also cannot explain this residual spread. Next, we show that state taxes on corporate bonds also cannot explain the residual. We note that the pure diffusion assumption may lead to underestimates of the default risk. In order to include jumps to default, we next estimate what combined jump-diffusion parameters would be necessary to force default spread to eliminate the residual spread. In each rating class on average firms would be required to experience annual jumps that decrease firm value by 20% and increase stock volatility by more than 100% over their observed volatility in order to eliminate the residual spread. We consider this required increase in stock volatility to be unrealistic as the sole explanation of the residual spread. So next we consider whether the unexplained component can be partly attributable to interest rates, liquidity, and market risk factors. We find the following empirical results: i) increases in liquidity as measured by changes in each firm’s trading volume significantly reduces the residual spread, but does not alter the default spread; ii) increases in stock market volatility significantly reduces the residual spread by increasing the default spread relative to the credit spread, and iii) increases in stock market returns significantly increases the residual spread by reducing the default spread relative to the credit spread. This paper concludes that credit risk and credit spreads are not primarily explained by default and recovery risk, but are mainly attributable to taxes, jumps, liquidity, and market risk factors.

https://escholarship.org/content/qt32x284q3/qt32x284q3.pdf

The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors - eScholarship

Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firm’s cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit derivatives. While rating agencies such as Moodys and Standard & Poors compute historical default frequencies, option models can also be used to calculate forward looking or expected default frequencies. In this paper, we compute risk neutral probabilities or default (RNPD) using the diffusion models of Merton (1974) and Geske (1977). It is shown that the Geske model produces a term structure of RNPD’s, and the shape of this term structure may forecast impending credit events. Next, it is shown that these RNPD’s serve as bounds to estimates of actual default probabilities. Furthermore, the RNPD’s exhibit the same comparative statics as the estimates of actual default probabilities. Also, the risk neutral default probabilities may be more accurately estimated than actual default probabilities because they do not require an estimate of the firm’s drift. Given these similarities and advantages of RNPD’s, their estimates may possess significant information about credit events. To confirm this an event study of the relation between RNPD and rating migrations is conducted. We first show that these RNPD’s from both the Merton and Geske models do possess significant and very early information about credit rating migrations.While the sample of firms that actually default during this time period is small, changes in the shape of the term structure of default probabilities appears to detect impending migrations to default. This is shown to be consistent with an inverted term structure of default probabilities, where prior to an impending default, the short term default probability is higher than the forward default probability. Finally, since rating migrations to either lower ratings or to default can be detected months in advance these credit events may not be a surprise.

/pdf/credit-risk-and-risk-neutral-default-probabilities-2c3q97i4mn.pdf

Credit risk and risk neutral default probabilities: information about rating migrations and defaults

This paper analyzes the components of corporate credit spreads. The analysis is based on a structural model that can offer a framework to understand the decomposition. The paper contends that default risk may correctly represent only a small portion of corporate credit spreads. This idea stems both from empirical evidence and from the following theoretical assumptions underlying contingent claim models of default: that markets for corporate stocks and bonds are (i) perfect, (ii) complete, and (iii) trading takes place continuously. Thus, in these models there are no transaction or bankruptcy costs, no tax effects, no liquidity effects, no jump effects reflecting market incompleteness, and no market risk factors effecting the pricing of corporate stocks or bonds. The paper starts with the use of a modified version of the Black-Scholes-Merton diffusion based option approach. We estimate corporate default spreads as simply a component of corporate credit spreads using data from November 1991 to December 1998, which includes the Asian Crisis in the Fall, 1998. First we measure the difference between the observed corporate credit spreads and option based estimates of default spreads. We define this difference as the residual spread. We show that for AAA (BBB) firms only a small percentage, 5% (22%), of the credit spread can be attributed to default risk. We show that recovery risk also cannot explain this residual spread. Next, we show that state taxes on corporate bonds also cannot explain the residual. We note that the pure diffusion assumption may lead to underestimates of the default risk. In order to include jumps to default, we next estimate what combined jump-diffusion parameters would be necessary to force default spread to eliminate the residual spread. In each rating class on average firms would be required to experience annual jumps that decrease firm value by 20% and increase stock volatility by more than 100% over their observed volatility in order to eliminate the residual spread. We consider this required increase in stock volatility to be unrealistic as the sole explanation of the residual spread. So next we consider whether the unexplained component can be partly attributable to interest rates, liquidity, and market risk factors. We find the following empirical results: i) increases in liquidity as measured by changes in each firm's trading volume significantly reduces the residual spread, but does not alter the default spread; ii) increases in stock market volatility significantly reduces the residual spread by increasing the default spread relative to the credit spread, and iii) increases in stock market returns significantly increases the residual spread by reducing the default spread relative to the credit spread. This paper concludes that credit risk and credit spreads are not primarily explained by default, leverage, firm specific risk, and recovery risk, but are mainly attributable to taxes, jumps, liquidity, and market risk factors.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID306479_code020713600.pdf?abstractid=306479&mirid=5

The Components of Corporate Credit Spreads: Default, Recovery, Taxes, Jumps, Liquidity, and Market Factors

/pdf/the-components-of-corporate-credit-spreads-default-recovery-1ym1n00xlh.pdf

The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors

Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firmâ€™s cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit derivatives. While rating agencies such as Moodys and Standard & Poors compute historical default frequencies, option models can also be used to calculate forward looking or expected default frequencies. In this paper, we compute risk neutral probabilities or default (RNPD) using the diffusion models of Merton (1974) and Geske (1977). It is shown that the Geske model produces a term structure of RNPDâ€™s, and the shape of this term structure may forecast impending credit events. Next, it is shown that these RNPDâ€™s serve as bounds to estimates of actual default probabilities. Furthermore, the RNPDâ€™s exhibit the same comparative statics as the estimates of actual default probabilities. Also, the risk neutral default probabilities may be more accurately estimated than actual default probabilities because they do not require an estimate of the firmâ€™s drift. Given these similarities and advantages of RNPDâ€™s, their estimates may possess significant information about credit events. To confirm this an event study of the relation between RNPD and rating migrations is conducted. We first show that these RNPDâ€™s from both the Merton and Geske models do possess significant and very early information about credit rating migrations.While the sample of firms that actually default during this time period is small, changes in the shape of the term structure of default probabilities appears to detect impending migrations to default. This is shown to be consistent with an inverted term structure of default probabilities, where prior to an impending default, the short term default probability is higher than the forward default probability. Finally, since rating migrations to either lower ratings or to default can be detected months in advance these credit events may not be a surprise.

Gordon Delianedis

Papers

The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors - eScholarship

Credit risk and risk neutral default probabilities: information about rating migrations and defaults

The Components of Corporate Credit Spreads: Default, Recovery, Taxes, Jumps, Liquidity, and Market Factors

The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors

Credit Risk and Risk Neutral Default Probabilities: Information About Migrations and Defaults