The Credit Spread: Risk-Free Rate in the Model
Abstract
This paper proposes a parsimonious credit spread estimation model for valuation of corporate bonds in data-scarce markets. We emphasize the importance of incorporating the risk-free rate directly into credit spread determination. Our model aligns with established literature and demonstrates the ability to capture the observed influence of risk-free rates on credit spreads across economies. We posit that models omitting the risk-free rate component may underestimate credit spreads, particularly impactful in emerging markets with elevated default probabilities and high risk-free rates. Finally, we discuss practical applications of the model, including exchange rate premium calculations, policy analysis, and negative yield spread analysis.
References
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[12] Chen, L., Lesmond, D. A. and Wei, J. (2007). Corporate Yield Spreads and Bond Liquidity. The Journal of Finance, 62 (1): 119-149. DOI: 10.1111/j.1540-6261.2007.01203.x
[13] Driessen, J. (2005). Is Default Event Risk Priced in Corporate Bonds? The Review of Financial Studies, 18 (1): 165-195. DOI: doi.org/10.1093/rfs/hhi009
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[15] Duffie, D., and Singleton, K. J. (1999). Modeling Term Structures of Defaultable Bonds. The Review of Financial Studies Special, 12 (4): 687-720. DOI: 10.1093/rfs/12.4.687
[16] Ericsson, J., Jacobs, K. and Oviedo, R. (2009). The Determinants of Credit Default Swap Premia. The Journal of Financial and Quantitative Analysis, 109-132. DOI: 10.1017/S0022109009090061
[17] Fabozzi, F. J., and Mann, S. V. (2005). The Handbook of Fixed Income Securities. The McGraw-Hill Companies.
[18] Garp, P. J. (2011). Vol. Sixth Edition, in Financial Risk Manager Handbook Plus Test Bank, 504-505. Hoboken, New Jersey: John Wiley and Sons, Inc.,.
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[21] Leland, H. E. (1994). Corporate Debt Value, Bond Covenants, and Optimal Capital Structure. The Journal of Finance 49: 1213-1252. DOI: 10.1111/j.1540-6261.1994.tb02452.x
[22] Lepone, A., and Wong, B. (2009). Determinants of Credit Spread Changes: Evidence from the Australian Bond Market. The Australasian Accounting Business and Finance Journal.
[23] Longstaff, F. A., and Schwartz, E. S. (1995). A Simple Approach to Valuing Risky Fixed and Floating Rate Debt. The Journal of Finance, 50 (3): 789-819. DOI:10.1111/j.1540-6261.1995.tb04037.x
[24] Longstaff, F.A., Mithal, S. and Neis, E. (2005). Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market. The Journal of Finance, 60 (5): 2213-2253. DOI:10.1111/j.1540-6261.2005.00797.x
[25] Maglione, F. (2024). Introducing and testing the Carr model of default. Quantitative Finance, 1–22. DOI:https://doi.org/10.1080/14697688.2024.2368081
[26] Melik-Parsadanyan, V., and Galstyan, A. (2017). Price and Yield of a Bond with Credit Risk. Alternative 4: 537-544.
[27] Merton, R.C. (1974). On The Pricing Of Corporate Debt: The Risk Structure. The Journal of Finance Volume 29 (2): 447-470. DOI: 10.1111/j.1540-6261.1974.tb03058.x
[28] Ohyama, S., and Sugimoto, T. (2007). The determinants of credit spread changes in Japan. Bank of Japan Working Paper Series.
[29] Petitt, B., Pinto, J. and Pirie, W. (2015). Fixed Income Analysis. 212-213; 308-315. CFA Institute.
[30] Pye, G. (1974). Gauging the Default Premium. Financial Analysts Journal, 30 (1): 49-52. DOI:10.2469/faj.v30.n1.49
[31] Radier, G., Majoni, A., Njanike, K. and Kwaramba, M. (2016). Determinants of bond yield spread changes in South Africa. African Review of Economics and Finance 50-81.
[32] Resti, A., and Sironi, A. (2007). Risk Management and Shareholders’ Value in Banking. From Risk Measurement Models to Capital Allocation Policies. West Sussex: John Wiley and Sons Ltd.
[33] Roggi, O. (2015). Risk, Value And Default. Singapore: World Scientific Publishing.
[34] Schwarz, K. (2019). Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads. Review of Finance, 23 (3): 557-597. DOI:10.1093/rof/rfy034
[35] Specht, L. (2023). An Empirical Analysis of European Credit Default Swap Spread Dynamics. Junior Management Science 1-42.
[36] Voloshyn, I. (2014). How to Treat Interest Losses in Estimation of Credit Risk Spread. August. Accessed May 17, 2020. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2475755
[2] Arce, M., et al. (2024). The Yields That Bind: Treasury Bill Yields and the Philippine. DLSU Business and Economics Review 34 (1). Available at: https://animorepository.dlsu.edu.ph/ber/vol34/iss1/30
[3] Bao, J., Pan, J. and Wang, J. (2011). The illiquidity of corporate bonds. The Journal of Finance, 66(3): 911-946. DOI: 10.1111/j.1540-6261.2011.01655.x
[4] Ben-Abdellatif, M., et al. (2024). A two-factor structural model for valuing corporate securities. Rev Deriv Res 27: 203-225. DOI: https://doi.org/10.1007/s11147-024-09203-2
[5] Bessis, J. (2002). Risk management in banking, 538-539. West Sussex, England: John Wiley and Sons Ltd.
[6] Bhanot, K., and Guo, L. (2011). Negative Credit Spreads: Liquidity and Limits to Arbitrage. The Journal of Fixed Income, 21 (1): 32-41. DOI: 10.3905/jfi.2011.21.1.032
[7] Black, F., and Cox, J. C. (1976). Valuing Corporate Securities: Some Effects Of Bond Indenture Provisions. The Journal of Finance, 31 (2): 351-367. DOI: 10.1111/j.1540-6261.1976.tb01891.x
[8] Boss, M., et al. (2009). Modeling Credit Risk through the Austrian Business Cycle: An Update of the OeNB Model. Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank) 85-101.
[9] Castro, V. (2012). Macroeconomic determinants of the credit risk in the banking system: The case of the GIPSI. NIPE Working Paper Series. Available at: http://www2.eeg.uminho.pt/economia/nipe/docs/2012/NIPE_WP_11_2012.pdf
[10] Chan-Lau, J. A. (2006). Market-Based Estimation of Default Probabilities and Its Application to Financial Market Surveillance. IMF Working Paper WP/06/104.
[11] Chen, H., Cui, R., He, Z. and Milbradt, K. (2014). Quantifying Liquidity And Default Risks of Corporate Bonds. NBER Working Paper Series Working Paper 20638.
[12] Chen, L., Lesmond, D. A. and Wei, J. (2007). Corporate Yield Spreads and Bond Liquidity. The Journal of Finance, 62 (1): 119-149. DOI: 10.1111/j.1540-6261.2007.01203.x
[13] Driessen, J. (2005). Is Default Event Risk Priced in Corporate Bonds? The Review of Financial Studies, 18 (1): 165-195. DOI: doi.org/10.1093/rfs/hhi009
[14] Duffee, G. R. (1998). The Relation Between Treasury Yields and Corporate Bond Yield Spreads. The Journal of Finance, 53 (6): 2225-2241. DOI: 10.1111/0022-1082.00089
[15] Duffie, D., and Singleton, K. J. (1999). Modeling Term Structures of Defaultable Bonds. The Review of Financial Studies Special, 12 (4): 687-720. DOI: 10.1093/rfs/12.4.687
[16] Ericsson, J., Jacobs, K. and Oviedo, R. (2009). The Determinants of Credit Default Swap Premia. The Journal of Financial and Quantitative Analysis, 109-132. DOI: 10.1017/S0022109009090061
[17] Fabozzi, F. J., and Mann, S. V. (2005). The Handbook of Fixed Income Securities. The McGraw-Hill Companies.
[18] Garp, P. J. (2011). Vol. Sixth Edition, in Financial Risk Manager Handbook Plus Test Bank, 504-505. Hoboken, New Jersey: John Wiley and Sons, Inc.,.
[19] He, Z., and Wei Xiong. (2012). Rollover Risk and Credit Risk. The Journal of Finance, 67 (2): 391-429. DOI:10.1111/j.1540-6261.2012.01721.x
[20] Hull, J.C. (2018). Risk Management and Financial Institutions. Haboken, New Jersey: John Wiley and Sons Inc.
[21] Leland, H. E. (1994). Corporate Debt Value, Bond Covenants, and Optimal Capital Structure. The Journal of Finance 49: 1213-1252. DOI: 10.1111/j.1540-6261.1994.tb02452.x
[22] Lepone, A., and Wong, B. (2009). Determinants of Credit Spread Changes: Evidence from the Australian Bond Market. The Australasian Accounting Business and Finance Journal.
[23] Longstaff, F. A., and Schwartz, E. S. (1995). A Simple Approach to Valuing Risky Fixed and Floating Rate Debt. The Journal of Finance, 50 (3): 789-819. DOI:10.1111/j.1540-6261.1995.tb04037.x
[24] Longstaff, F.A., Mithal, S. and Neis, E. (2005). Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market. The Journal of Finance, 60 (5): 2213-2253. DOI:10.1111/j.1540-6261.2005.00797.x
[25] Maglione, F. (2024). Introducing and testing the Carr model of default. Quantitative Finance, 1–22. DOI:https://doi.org/10.1080/14697688.2024.2368081
[26] Melik-Parsadanyan, V., and Galstyan, A. (2017). Price and Yield of a Bond with Credit Risk. Alternative 4: 537-544.
[27] Merton, R.C. (1974). On The Pricing Of Corporate Debt: The Risk Structure. The Journal of Finance Volume 29 (2): 447-470. DOI: 10.1111/j.1540-6261.1974.tb03058.x
[28] Ohyama, S., and Sugimoto, T. (2007). The determinants of credit spread changes in Japan. Bank of Japan Working Paper Series.
[29] Petitt, B., Pinto, J. and Pirie, W. (2015). Fixed Income Analysis. 212-213; 308-315. CFA Institute.
[30] Pye, G. (1974). Gauging the Default Premium. Financial Analysts Journal, 30 (1): 49-52. DOI:10.2469/faj.v30.n1.49
[31] Radier, G., Majoni, A., Njanike, K. and Kwaramba, M. (2016). Determinants of bond yield spread changes in South Africa. African Review of Economics and Finance 50-81.
[32] Resti, A., and Sironi, A. (2007). Risk Management and Shareholders’ Value in Banking. From Risk Measurement Models to Capital Allocation Policies. West Sussex: John Wiley and Sons Ltd.
[33] Roggi, O. (2015). Risk, Value And Default. Singapore: World Scientific Publishing.
[34] Schwarz, K. (2019). Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads. Review of Finance, 23 (3): 557-597. DOI:10.1093/rof/rfy034
[35] Specht, L. (2023). An Empirical Analysis of European Credit Default Swap Spread Dynamics. Junior Management Science 1-42.
[36] Voloshyn, I. (2014). How to Treat Interest Losses in Estimation of Credit Risk Spread. August. Accessed May 17, 2020. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2475755
Published
2024-09-30
How to Cite
GHAZARYAN, Amasya; ASOYAN, Satine; MELIK-PARSADANYAN, Vahagn.
The Credit Spread: Risk-Free Rate in the Model.
Theoretical and Practical Research in Economic Fields, [S.l.], v. 15, n. 3, p. 647 - 658, sep. 2024.
ISSN 2068-7710.
Available at: <https://journals.aserspublishing.eu/tpref/article/view/8594>. Date accessed: 21 dec. 2024.
doi: https://doi.org/10.14505/tpref.v15.3(31).11.
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