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

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  • Delianedis, Gordon
  • Geske, Robert

Abstract

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.

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Bibliographic Info

Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt32x284q3.

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Date of creation: 01 Dec 2001
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Handle: RePEc:cdl:anderf:qt32x284q3

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Citations

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Cited by:
  1. Alexandros Benos & George Papanastasopoulos, 2005. "Extending the Merton Model: A Hybrid Approach to Assessing Credit Quality," Finance, EconWPA 0505020, EconWPA, revised 03 Jun 2005.
  2. Li Chen & H. Vincent Poor, 2003. "Credit Risk Modeling and the Term Structure of Credit Spreads," Finance, EconWPA 0312009, EconWPA.
  3. Jing-zhi Huang & Hao Zhou, 2008. "Specification analysis of structural credit risk models," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2008-55, Board of Governors of the Federal Reserve System (U.S.).
  4. George Tauchen & Hao Zhou, 2006. "Realized jumps on financial markets and predicting credit spreads," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2006-35, Board of Governors of the Federal Reserve System (U.S.).
  5. Jakub Seidler, 2008. "Implied Market Loss Given Default: structural-model approach," Working Papers IES, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies 2008/26, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Oct 2008.
  6. Abel Elizalde, 2006. "Credit Risk Models Ii: Structural Models," Working Papers, CEMFI wp2006_0606, CEMFI.
  7. Andrew T. Levin & Fabio M. Natalucci & Egon Zakrajsek, 2004. "The magnitude and cyclical behavior of financial market frictions," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2004-70, Board of Governors of the Federal Reserve System (U.S.).
  8. Sergio Mayordomo & Juan Ignacio Peña & Eduardo S. Schwartz, 2010. "Are all Credit Default Swap Databases Equal?," NBER Working Papers 16590, National Bureau of Economic Research, Inc.
  9. Donald P. Morgan & Kevin J. Stiroh, 2005. "Too big to fail after all these years," Staff Reports 220, Federal Reserve Bank of New York.
  10. Maciej Firla-Cuchra & Tim Jenkinson, 2005. "Security Design in the Real World: Why are Securitization Issues Tranched?," Economics Series Working Papers 225, University of Oxford, Department of Economics.
  11. Maciej Firla-Cuchra, 2005. "Explaining Launch Spreads on Structured Bonds," Economics Series Working Papers 230, University of Oxford, Department of Economics.
  12. Ericsson, Jan & Reneby, Joel, 2003. "Valuing Corporate Liabilities," SIFR Research Report Series, Institute for Financial Research 15, Institute for Financial Research.

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