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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 that can be explained by factors such as the possibility of default, liquidity, tax differentials and market risk. We contribute to this literature by assessing the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion of 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 and Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond yields as well as credit default swap premia. The model is calibrated with consumption, inflation, risk-free yields and default data for Aa, A and Baa bonds from the 1987-2008 period. We find that our macroeconomic factors are linked with two out of three sharp increases in the spreads during this sample period, indicating that the variations can be related to macroeconomic undiversifiable risk. The estimated default spreads can explain almost half of the 10 years to maturity industrial Baa zero-coupon yields in some regime. Much smaller proportions are found for Aa and A bonds with numbers around 10%. The proportions of default estimated with credit default swaps are higher, in many cases doubling those found with corporate yield spreads.

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Bibliographic Info

Paper provided by CIRPEE in its series Cahiers de recherche with number 1042.

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Date of creation: 2010
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Handle: RePEc:lvl:lacicr:1042

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Keywords: Credit spread; default spread; Markov switching; macroeconomic factors; reduced form model of default; random subjective discount factor; credit default swap; CDS;

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Citations

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Cited by:
  1. Chevallier, Julien, 2011. "A model of carbon price interactions with macroeconomic and energy dynamics," Energy Economics, Elsevier, Elsevier, vol. 33(6), pages 1295-1312.
  2. Georges Dionne & Pascal François & Olfa Maalaoui Chun, 2009. "Detecting Regime Shifts in Corporate Credit Spreads," Cahiers de recherche, CIRPEE 0929, CIRPEE.
  3. 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.
  4. Chevallier, Julien, 2011. "Evaluating the carbon-macroeconomy relationship: Evidence from threshold vector error-correction and Markov-switching VAR models," Economics Papers from University Paris Dauphine 123456789/6970, Paris Dauphine University.
  5. 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.
  6. repec:hal:journl:halshs-00658540 is not listed on IDEAS
  7. Badye Essid & Tolga Cenesizoglu, 2010. "The Effect of Monetary Policy on Credit Spreads," 2010 Meeting Papers 1139, Society for Economic Dynamics.
  8. Bazán, Walter, 2011. "No-linealidades y asimetrías en el crédito peruano," Working Papers, Banco Central de Reserva del Perú 2011-015, Banco Central de Reserva del Perú.
  9. Timothée Papin & Gabriel Turinici, 2012. "Prepayment option of a perpetual corporate loan: the impact of the funding costs," Working Papers hal-00768571, HAL.
  10. Georges Dionne & Olfa Maalaoui Chun, 2013. "Default and Liquidity Regimes in the Bond Market during the 2002-2012 Period," Cahiers de recherche, CIRPEE 1322, CIRPEE.
  11. Timothée Papin & Gabriel Turinici, 2014. "Prepayment option of a perpetual corporate loan: the impact of the funding costs," Post-Print hal-00768571, HAL.
  12. Adrian Cantemir CALIN & Oana Cristina POPOVICI, 2014. "Modeling Credit Risk Through Credit Scoring," Internal Auditing and Risk Management, Athenaeum University of Bucharest, Athenaeum University of Bucharest, vol. 2(34), pages 99-109, June.
  13. Papin, Timothée, 2013. "Pricing of Corporate Loan : Credit Risk and Liquidity cost," Economics Thesis from University Paris Dauphine, Paris Dauphine University, number 123456789/12545 edited by Turinici, Gabriel, October.

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