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Diversification with idiosyncratic credit spreads: a pooled estimation on heterogeneous panels

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  • Lin, William
  • Sun, David

Abstract

Following the method of Pesaran, Shin and Smith (1999), this study extends the results of Sun, Lin and Nieh (2007) to investigate the risk diversification issue of individual corporate bonds in portfolios. This is one of the few studies on the decomposition of individual corporate yield spreads. Specifically we adopt the robust econometric method of ARDL-based Pooled Mean Group cointegration analysis on panels of corporate bond data which yields results with rich economic implications for fixed income portfolio management. Empirical decomposition of yield spreads indicates, on the individual corporate bond level, that the idiosyncratic component serves as a good vehicle for risk diversification while considering long run market behavior. In the long run systematic credit spreads are found to be consistent with the agency hypothesis where higher interest rate raises endogenous default risk and it is particularly meaningful for the Taiwanese capital market. Option hypothesis of the structural approach is still valid in the short run in predicting yield spreads to be inversely related to interest rate. Our findings contribute in general to the risk practice of bond portfolio diversification. In particular, the pooled estimation we conducted proves to be superior in working with individual corporate bond data panels and helps related studies in the area.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 37288.

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Date of creation: Sep 2006
Date of revision: Jun 2007
Publication status: Published in Taiwan Banking and Finance Quarterly 8.2(2007): pp. 1-24
Handle: RePEc:pra:mprapa:37288

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Keywords: bond pricing; credit spread; diversifiable risk; cointegration; heterogeneous panels; pooled mean group estimation;

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  1. Robert A. Jarrow & David Lando & Fan Yu, 2005. "Default Risk And Diversification: Theory And Empirical Implications," Mathematical Finance, Wiley Blackwell, Wiley Blackwell, vol. 15(1), pages 1-26.
  2. Gregory R. Duffee, 1996. "Estimating the price of default risk," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 96-29, Board of Governors of the Federal Reserve System (U.S.).
  3. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 247-277, 02.
  4. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, American Finance Association, vol. 56(6), pages 2177-2207, December.
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  9. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
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  11. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 50(1), pages 53-85, March.
  12. Thomas C. Wilson, 1998. "Portfolio credit risk," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Oct, pages 71-82.
  13. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, American Finance Association, vol. 57(1), pages 405-443, 02.
  14. Jun Liu & Francis A. Longstaff & Ravit E. Mandell, 2006. "The Market Price of Risk in Interest Rate Swaps: The Roles of Default and Liquidity Risks," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 79(5), pages 2337-2360, September.
  15. 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.
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