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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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Related research

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

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  1. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
  2. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
  3. 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, vol. 79(5), pages 2337-2360, September.
  4. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  5. Hayette Gatfaoui, 2003. "Risk Disaggregation And Credit Risk Valuation In The Merton Like Way," Finance 0308007, EconWPA.
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  7. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  8. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  9. Robert A. Jarrow & David Lando & Fan Yu, 2005. "Default Risk And Diversification: Theory And Empirical Implications," Mathematical Finance, Wiley Blackwell, vol. 15(1), pages 1-26.
  10. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, vol. 53(6), pages 2225-2241, December.
  11. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, 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, issue Oct, pages 71-82.
  13. 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.
  14. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
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