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An empirical study of credit spreads in an emerging market: The case of Korea

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  • Park, Keehwan
  • Ahn, Chang Mo
  • Kim, Dohyeon
  • Kim, Saekwon
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    Abstract

    Empirically we test the Merton-type model (1974) of credit risk in an emerging market such as the Korean corporate bond market. For that purpose, we assume two alternative firm value processes: diffusion process for the Merton (1974) model and jump-diffusion process for our extended model in a general equilibrium setting. Our empirical results show that the diffusion model generally underpredicts spreads — which is referred to as “the credit spread underprediction puzzle” in the literature, while our jump-diffusion model somewhat raises the predicted spreads. We assert that jump raises the spreads on two grounds. First, an extremely large (negative) change tends to increase the probability for a firm to default particularly over a short-time horizon. Second, jump requires the systematic risk premium for a positively correlated firm particularly when the market turns extremely volatile.

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    Bibliographic Info

    Article provided by Elsevier in its journal Pacific-Basin Finance Journal.

    Volume (Year): 21 (2013)
    Issue (Month): 1 ()
    Pages: 952-966

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    Handle: RePEc:eee:pacfin:v:21:y:2013:i:1:p:952-966

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    Web page: http://www.elsevier.com/locate/pacfin

    Related research

    Keywords: Diffusion process; Jump-diffusion process; Credit risk; Spread underprediction puzzle; Risk-neutral probability distribution;

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    1. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-25, July.
    2. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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    11. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
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    14. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    15. Ahn, Chang Mo & Thompson, Howard E, 1988. " Jump-Diffusion Processes and the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 43(1), pages 155-74, March.
    16. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04.
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    Cited by:
    1. Heshmati, Almas, 2013. "The Effect of Credit Guarantees on R&D Investment of SMEs in Korea," IZA Discussion Papers 7851, Institute for the Study of Labor (IZA).

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