An empirical investigation of the short-term relationship betweeninterest rate risk and credit risk

Empirical results from several studies indicate that changes in interest rates andchanges in credit spreads are negatively related in the short run. These findings arefurther investigated by examining the dependence structure between interest rateand credit risk factor changes that are computed from sovereign and corporatebond indices. Several copulas (Gaussian, Student t, BB1, and Frank copula) arecalibrated and their goodness-of-fit is compared. No clear pattern of thedependence structure can be observed as it varies substantially with the durationand – concerning the credit risk factor changes – the rating of the obligors. TheStudent t copula’s fit in terms of the AIC goodness-of-fit measure is superior tothat of all other copulas. The null hypothesis of a specific copula being the truecopula can be rejected for the Student t copula in the least cases. Additionallyemploying a likelihood-ratio test, the null hypothesis of a Gaussian copula can berejected in favour of a Student t copula. The Gaussian copula seems tounderestimate the probability of joint strong risk factor changes, while the Studentt copula seems to overestimate it.