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US Corporate Bond Yield Spread: A default risk debate

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  • SHAH, Syed Muhammad Noaman Ahmed
  • KEBEWAR, mazen
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    Abstract

    According to theoretical models of valuing risky corporate securities, risk of default is primary component in overall yield spread. However, sizable empirical literature considers it otherwise by giving more importance to non-default risk factors. Current study empirically attempts to provide relative solution to this conundrum by presuming that problem lies in the subjective empirical treatment of default risk. By using post-hoc estimator approach of Lubotsky & Wittenberg (2006), we construct an efficient indicator for risk of default, by using sample of 252 US non-financial corporate data (2000-2010). On average, our results validate that almost 48% of change in yield spread is explained by default risk especially in recent financial crisis period (2007-2009). Hence, our results relatively suggest that potential problem lies in the ad-hoc measurement methods used in existing empirical literature

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    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 44887.

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    Date of creation: 08 Mar 2013
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    Handle: RePEc:pra:mprapa:44887

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    Keywords: Default risk; credit spread; risk-aversion; measurement error; index construction;

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    1. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
    2. Chance, Don M, 1990. " Default Risk and the Duration of Zero Coupon Bonds," Journal of Finance, American Finance Association, vol. 45(1), pages 265-74, March.
    3. Darren Lubotsky & Martin Wittenberg, 2001. "Interpretation of Regressions with Multiple Proxies," Working Papers 836, Princeton University, Department of Economics, Industrial Relations Section..
    4. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    5. Jan Ericsson & Olivier Renault, 2006. "Liquidity and Credit Risk," Journal of Finance, American Finance Association, vol. 61(5), pages 2219-2250, October.
    6. Dick-Nielsen, Jens & Feldh├╝tter, Peter & Lando, David, 2012. "Corporate bond liquidity before and after the onset of the subprime crisis," Journal of Financial Economics, Elsevier, vol. 103(3), pages 471-492.
    7. 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.
    8. Tang, Dragon Yongjun & Yan, Hong, 2008. "Market conditions, default risk and credit spreads," Discussion Paper Series 2: Banking and Financial Studies 2008,08, Deutsche Bundesbank, Research Centre.
    9. Tsuji, Chikashi, 2005. "The credit-spread puzzle," Journal of International Money and Finance, Elsevier, vol. 24(7), pages 1073-1089, November.
    10. Lawrence Fisher, 1959. "Determinants of Risk Premiums on Corporate Bonds," Journal of Political Economy, University of Chicago Press, vol. 67, pages 217.
    11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    12. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, vol. 23(4), pages 589-609, 09.
    13. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-25, July.
    14. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
    15. Liu, Sheen & Shi, Jian & Wang, Junbo & Wu, Chunchi, 2009. "The determinants of corporate bond yields," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(1), pages 85-109, February.
    16. 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.
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