Modelling credit spreads on yen Eurobonds within an equilibrium correction framework
This study develops an equilibrium correction model (ECM) of thecredit spreads on quality Japanese yen Eurobonds based on the Longstaffand Schwartz (1995) continuous time, closed form solution of thearbitrage-free value on risky debt. The solution predicts testable relationshipsbetween the credit spread and several important factors involved,including the risk-free interest rate, firm asset volatility, and the firm assetreturn correlation with changes in the risk-free rate. In the frictionlesscontinuous time approach a key assumption is that the markets adjustwithout delays to the new equilibrium. In reality, however, adjustmentstake time, such that the markets may be temporally out of the equilibrium.The results of this study show that unlike other findings from the USA,Japanese spreads are stationary. Accordingly, an implied equilibriumcorrection procedure is incorporated into the modelling process. Whiletraditional theories of credit-spread behaviour predict that changes in therisk free interest rate and asset factors arc negatively correlated withchanges in credit spreads on risky bonds, it is found that the asset factor, asproxied by the change in the stock market index. has only a very limitedeffect. whereas the interest rate factor has the over-riding influence both inthe long and short run. Furthermore. whereas an increase in asset volatilityshould have an increasing effect on the credit spread, it is found that theprevailing spread change volatility has a more pronounced effect. There isalso evidence that changes in the term structure affects both the long runequilibrium as well as the short run changes in the spread. Furthermore,the asset return correlation with the risk free rate receives empiricalsupport to affect the credit spread in the manner predicted by theLongstaff and Schwartz (1995) theoretical model.
|Year of publication:||
|Authors:||Pynnonen Seppo ; Hogan Warren ; Batten Jonathan|
|Type of publication:||Other|
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