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A Reduced Form Model of Default Spreads with Markov Switching Macroeconomic Factors

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  • Georges Dionne
  • Geneviève Gauthier
  • Khemais Hammami
  • Mathieu Maurice
  • Jean-Guy Simonato

Abstract

An important research area of the corporate yield spread literature seeks to measure the proportion of the spread explained by factors such as the possibility of default, liquidity or tax differentials. We contribute to this literature by assessing the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion in yield spreads caused by the risk of default in the context of a reduced form model. For this purpose, we extend the Markov Switching risk-free term structure model of Bansal ad Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond yields. The model is calibrated out of sample with consumption, inflation, risk-free yield and default data over the 1987-1996 period. Our results indicate that inflation is a key factor to consider for explaining default spreads during our sample period. We also find that the estimated default spreads can explain up to half of the 10 year to maturity Baa zero-coupon yield in certain regime with different sensitivities to consumption and inflation through time.

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Bibliographic Info

Paper provided by CIRPEE in its series Cahiers de recherche with number 0741.

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Date of creation: 2007
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Handle: RePEc:lvl:lacicr:0741

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Keywords: Credit spread; default spread; Markov Switching; macroeconomic factors; reduced form model of default;

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Citations

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Cited by:
  1. Georges Dionne & Olfa Maalaoui Chun, 2013. "Default and liquidity regimes in the bond market during the 2002-2012 period," Canadian Journal of Economics, Canadian Economics Association, vol. 46(4), pages 1160-1195, November.
  2. Timothée Papin & Gabriel Turinici, 2012. "Prepayment option of a perpetual corporate loan: the impact of the funding costs," Working Papers hal-00768571, HAL.
  3. Badye Essid & Tolga Cenesizoglu, 2010. "The Effect of Monetary Policy on Credit Spreads," 2010 Meeting Papers 1139, Society for Economic Dynamics.
  4. Mathieu Gatumel & Florian Ielpo, 2011. "The Number of Regimes Across Asset Returns: Identification and Economic Value," Post-Print halshs-00658540, HAL.
  5. Bazán, Walter, 2011. "No-linealidades y asimetrías en el crédito peruano," Working Papers 2011-015, Banco Central de Reserva del Perú.
  6. Georges Dionne & Pascal François & Olfa Maalaoui Chun, 2009. "Detecting Regime Shifts in Corporate Credit Spreads," Cahiers de recherche 0929, CIRPEE.
  7. Chevallier, Julien, 2012. "Global imbalances, cross-market linkages, and the financial crisis : a multivariate Markov-Switching analysis," Economics Papers from University Paris Dauphine 123456789/8773, Paris Dauphine University.
  8. Mathieu Gatumel & Florian Ielpo, 2011. "The Number of Regimes Across Asset Returns: Identification and Economic Value," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00658540, HAL.

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