An empirical study of credit spreads in an emerging market: The case of Korea

Empirically we test the Merton-type model (1974) of credit risk in an emerging market such as the Korean corporate bond market. For that purpose, we assume two alternative firm value processes: diffusion process for the Merton (1974) model and jump-diffusion process for our extended model in a general equilibrium setting. Our empirical results show that the diffusion model generally underpredicts spreads — which is referred to as “the credit spread underprediction puzzle” in the literature, while our jump-diffusion model somewhat raises the predicted spreads. We assert that jump raises the spreads on two grounds. First, an extremely large (negative) change tends to increase the probability for a firm to default particularly over a short-time horizon. Second, jump requires the systematic risk premium for a positively correlated firm particularly when the market turns extremely volatile.