An Econometric Model of Credit Spreads with Rebalancing, ARCH and Jump Effects

Abstract

An Econometric Model of Credit Spreads withRebalancing, ARCH, and Jump EffectsIn this paper, we examine the dynamic behavior of credit spreads on corporate bond portfolios. We propose an econometric model of credit spreads that incorporates portfolio rebalancing, the near unit root property of spreads, the autocorrelation in spread changes, the ARCH conditional heteroscedasticity, jumps, and lagged market factors. In particular, our model is the first that takes into account explicitly the impact of rebalancing and yields estimates of the absorbing bounds on credit spreads induced by such rebalancing. We apply our model to nine Merrill Lynch daily series of option-adjusted spreads with ratings from AAA to C for the period January, 1997 through August, 2002. We find no evidence of mean reversion in these credit spread series over our sample period. However, we find ample evidence of both the ARCH effect and jumps in the data especially in the investmentgrade credit spread indices. Incorporating jumps into the ARCH type conditional variance results in significant improvements in model diagnostic tests. We also find that while log spread variations depend on both the lagged Russell 2000 index return and lagged changes in the slope of the yield curve, the time-varying jump intensity of log credit spreads is correlated with the lagged stock market volatility. Finally, our results indicate the ARCHjump specification outperforms the ARCH specification in the out-of-sample, one-stepahead forecast of credit spreads.JEL Classification Codes: C22, C13, C53, G12.

Fundamental determinants of credit default risk for European and American banks

“…It is connected with the unit root and heteroscedasticity in credit spreads (Pedrosa, Roll, 1998;Bierens et al, 2003). To verify the presented phenomenon a lagged dependent variable (Blanco et al, 2005) has been used.…”

The impact of the global financial crisis on the cross-currency linkage of LIBOR–OIS spreads

“…Duffee (1999) also argues that individual bond credit spreads follow a stationary process. On the other hand, Pedrosa and Roll (1998) and Bierens et al (2003) find that a vast majority of credit spread indices are non-stationary in their empirical results. Hence, the unit root test results here are likely to be period-specific, given that evidence for non-stationarity in the LIBOR-OIS spreads only appears during the crisis period.…”

The role of managerial risk‐taking in the ‘rise and fall’ of the CDS market

“…The dynamic specification is also motivated by findings by Bierens et al . () and Blanco et al . ().…”