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

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Author Info

  • Ken Hung

    (Department of Finance, National Dong Hwa University)

  • Chang-Wen Duan

    (Department of Finance, Tamkang University)

  • Chin W. Yang

    (Department of Economics, Clarion University)

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    Abstract

    This 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 Duffee (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.

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    Bibliographic Info

    Article provided by Society for AEF in its journal Annals of Economics and Finance.

    Volume (Year): 7 (2006)
    Issue (Month): 2 (November)
    Pages: 405-424

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    Handle: RePEc:cuf:journl:y:2006:v:7:i:2:p:405-424

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    Related research

    Keywords: Credit spread; Default risk; Interest rate risk; Market price of risk; Put-call parity; VaR (Value at Risk);

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    References

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    1. Rabinovitch, Ramon, 1989. "Pricing Stock and Bond Options when the Default-Free Rate is Stochastic," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 24(04), pages 447-457, December.
    2. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, American Finance Association, vol. 50(3), pages 789-819, July.
    3. Pindyck, Robert S., 1993. "Investments of uncertain cost," Journal of Financial Economics, Elsevier, Elsevier, vol. 34(1), pages 53-76, August.
    4. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    5. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    6. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, American Finance Association, vol. 53(6), pages 2225-2241, December.
    7. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    8. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 12(04), pages 627-627, November.
    9. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 385-407, March.
    10. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 177-188, November.
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