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# Rating, Credit Spread, and Pricing Risky Debt: Empirical Study on Taiwan's Security Market

01 Jan 2006-Annals of Economics and Finance (Society for AEF)-Vol. 7, Iss: 2, pp 405-424

AbstractThis paper focuses on evaluating the credit risk of corporate bond in the fixed income market of Taiwan. We apply Vasicek (1977) model into Merton’s (1974) option framework and obtain a closed-form solution of the options model. The solution algorithm employs the Newton-Raphson method in combination with the inverse quadratic interpolation and bisection technique of Dekker (1967) to find out the roots and calculate the credit spread. The result shows that the average credit spread is 1.346%, and the credit spread of TSE (Taiwan Stock Exchange) listed firm is higher than that of OTC firms, while the one with bank guarantee is higher than the one without. We find negative correlation between VaR rating, TEJ (Taiwan Economic Journal) rating and credit spread, implying that the higher the market risk is, the lower the required premium is by the bondholders, and credit spread is expected to be lower. Testing the hypothesis of Duee (1998), we find a negative correlation between the Taiwan Stock weighted index and credit spread. It implies that the term structure of interest rate is an upward type. As firm’s equity value rises, the index return follows suit. While the bond default probability decreases, and the credit spread is expected to decrease. c 2006 Peking University Press

Topics: , Credit risk (65%), iTraxx (65%), Credit crunch (64%)

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Abstract: This paper uses credit spread data on Japanese bond indices to examine the possibility of a change in the determinants of daily credit spreads after the outbreak of the global financial crisis of 2007. A set of variables identified by prior research are used in a GARCH setting to explain credit spread changes both before and after the start of the crisis. The findings indicate that, overall, the coefficient estimates of the two bond market factors, namely changes in the spot rate and changes in the slope of the treasury yield curve, are consistent with prior literature. Moreover, the direction of the relationship is the same during the two periods. On the other hand, the relationship between credit spread changes and the two stock market factors, namely stock market index returns and changes in the implied index option volatility, is weak and sensitive to the period examined. Finally, the liquidity factor has a weak impact in both periods. It is also notable that the explanatory power of the empirical model used in the paper falls during the crisis.

2 citations

Journal ArticleDOI
Abstract: In this study, we investigate the determinants of credit spread using a Markov regime-switching model. We consider corporate governance variables and credit risk to analyze the determinants of credit spread. The corporate governance mechanism is an indicator of company sustainability, and credit spread is the main factor in profits obtained by banks. However, the relationship between credit spread and corporate governance is seldom discussed. We focus on loans from banks in Taiwan between 2000 and 2019 and apply a Markov regime-switching model, which is superior to other models in capturing different effects in various regimes. We specify two regime types: corporate governance and credit risk regimes. Furthermore, we consider four aspects of corporate governance: firm ownership structure, board structure, deviation, and information environment. In this study, the determinants of credit spread are investigated more thoroughly than in previous studies. Moreover, in this study, we examine the effects of monetary policy and economic status on credit spread using a Markov regime-switching model; such models are not employed to their full extent in related studies of credit spread. Empirical results indicate that credit spread has different effects in various regimes. Thus, understanding the determinants of credit spread in different regimes is crucial for financial analysts, investors, economic policymakers, and banks. Consequently, we expect that this study can improve the management and measurement of credit risk and be of value to financial institutions.

1 citations

##### References
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Journal ArticleDOI
Abstract: If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.

27,108 citations

### "Rating, Credit Spread, and Pricing ..." refers background or methods in this paper

• ...Default risk may also be translated into adjusted discount rate, referred as the reduced-form model....

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• ...However, both models of Black and Scholes (1973) and Merton (1974) are weakened by assuming constant interest rate....

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• ...The Pull-Call Parity of Black and Scholes (1973) can be shown as follows: Pt + St = Ct + Ke−r τ f (1) where St, Ct, Pt,K, rf , and τ are the underlying asset, the call options value, the put options value, the exercise price, the risk-free rate and the maturity date, respectively....

[...]

• ...Its concept is that of a valuation method based on the options valuation model of Black and Scholes (1973) to set up a theory of the risk structure of interest rate, and thereby derive bond value....

[...]

Journal ArticleDOI
Abstract: We discuss the following problem given a random sample X = (X 1, X 2,…, X n) from an unknown probability distribution F, estimate the sampling distribution of some prespecified random variable R(X, F), on the basis of the observed data x. (Standard jackknife theory gives an approximate mean and variance in the case R(X, F) = $$\theta \left( {\hat F} \right) - \theta \left( F \right)$$, θ some parameter of interest.) A general method, called the “bootstrap”, is introduced, and shown to work satisfactorily on a variety of estimation problems. The jackknife is shown to be a linear approximation method for the bootstrap. The exposition proceeds by a series of examples: variance of the sample median, error rates in a linear discriminant analysis, ratio estimation, estimating regression parameters, etc.

13,648 citations

Journal ArticleDOI
Abstract: Presented at the American Finance Association Meeting, New York, December 1973.(This abstract was borrowed from another version of this item.)

10,799 citations

### "Rating, Credit Spread, and Pricing ..." refers background or methods in this paper

• ...However, both models of Black and Scholes (1973) and Merton (1974) are weakened by assuming constant interest rate....

[...]

• ...As pointed 1In Taiwan, more than 90% of bond trade is completed in OTC market of which, financial institution accounting for more than 60% of the trading volume is the primary dealer....

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• ...Furthermore, the firm valuation model of Merton (1973, 1974) is frequently applied by researcher....

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Book
12 Sep 2011
Abstract: The long history of the theory of option pricing began in 1900 when the French mathematician Louis Bachelier deduced an option pricing formula based on the assumption that stock prices follow a Brownian motion with zero drift. Since that time, numerous researchers have contributed to the theory. The present paper begins by deducing a set of restrictions on option pricing formulas from the assumption that investors prefer more to less. These restrictions are necessary conditions for a formula to be consistent with a rational pricing theory. Attention is given to the problems created when dividends are paid on the underlying common stock and when the terms of the option contract can be changed explicitly by a change in exercise price or implicitly by a shift in the investment or capital structure policy of the firm. Since the deduced restrictions are not sufficient to uniquely determine an option pricing formula, additional assumptions are introduced to examine and extend the seminal Black-Scholes theory of option pricing. Explicit formulas for pricing both call and put options as well as for warrants and the new "down-and-out" option are derived. The effects of dividends and call provisions on the warrant price are examined. The possibilities for further extension of the theory to the pricing of corporate liabilities are discussed.

9,360 citations

### "Rating, Credit Spread, and Pricing ..." refers background or methods in this paper

• ...However, these methods fail to evaluate corporate credit risk and explain clearly the risk exposure of an underlying asset....

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• ...Merton (1973) considers all out-circulating bond to be a contingent claim2 of the corporate value....

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• ...We imbed the Vasicek (1977) model into the valuation model of Merton (1973) and employ the Newton-Raphson numerical method together with the inverse quadratic interpolation and bisection technique of Dekker (1967) to obtain nonlinear roots, and finally derive the credit spread of firms....

[...]

• ...Furthermore, the firm valuation model of Merton (1973, 1974) is frequently applied by researcher....

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• ...…risky bond value: VD = VA − VAN(k1) + Fer τ f N(k2) (10) where k1 = (ln(VA/FP (r, τ)) + T/2)/ √ T , k2 = k1 − √ T T = σ2τ + (τ − 2B + (1− exp[−2qτ ])/2q)(ν/q)2 − 2ρσ(τ −B)ν/q (11) dz1dz2 = ρdt (12) Note that the composition elements in the equations (10) to (12) differ from those by Merton (1973)....

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Journal ArticleDOI
Abstract: This paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. In this model, anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices. Many of the factors traditionally mentioned as influencing the term structure are thus included in a way which is fully consistent with maximizing behavior and rational expectations. The model leads to specific formulas for bond prices which are well suited for empirical testing. 1. INTRODUCTION THE TERM STRUCTURE of interest rates measures the relationship among the yields on default-free securities that differ only in their term to maturity. The determinants of this relationship have long been a topic of concern for economists. By offering a complete schedule of interest rates across time, the term structure embodies the market's anticipations of future events. An explanation of the term structure gives us a way to extract this information and to predict how changes in the underlying variables will affect the yield curve. In a world of certainty, equilibrium forward rates must coincide with future spot rates, but when uncertainty about future rates is introduced the analysis becomes much more complex. By and large, previous theories of the term structure have taken the certainty model as their starting point and have proceeded by examining stochastic generalizations of the certainty equilibrium relationships. The literature in the area is voluminous, and a comprehensive survey would warrant a paper in itself. It is common, however, to identify much of the previous work in the area as belonging to one of four strands of thought. First, there are various versions of the expectations hypothesis. These place predominant emphasis on the expected values of future spot rates or holdingperiod returns. In its simplest form, the expectations hypothesis postulates that bonds are priced so that the implied forward rates are equal to the expected spot rates. Generally, this approach is characterized by the following propositions: (a) the return on holding a long-term bond to maturity is equal to the expected return on repeated investment in a series of the short-term bonds, or (b) the expected rate of return over the next holding period is the same for bonds of all maturities. The liquidity preference hypothesis, advanced by Hicks [16], concurs with the importance of expected future spot rates, but places more weight on the effects of the risk preferences of market participants. It asserts that risk aversion will cause forward rates to be systematically greater than expected spot rates, usually

6,763 citations