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Abstract:
In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model with a constant recovery rate outperforms the market practice of directly comparing bonds' credit spreads to default swap premiums. We find that the model works well for investment grade credit default swaps, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is insensitive to the value of the assumed recovery rate.

credit default swaps, credit derivatives, credit risk, default risk, risk-neutral valuation, default-free interest rates

Abstract:
We present a new framework for the joint estimation of the default-free term structure of interest rates and corporate credit spread curves. It specifies the discount curve of a specific credit rating class as the sum of the government discount function and a discount spread function. Both functions are modelled using splines so that we can jointly estimate the default-free government term structure and corporate credit spread curves with least squares. We construct confidence intervals around the estimated term structures and credit spreads and use them to determine the number of knots and the order of the involved spline functions. By using a high-quality data set of German mark denominated bonds, we show that the new framework yields more realistic spreads than conventionally obtained spread curves that result from subtracting independently estimated government and corporate term structures. The estimated spread curves are now smooth functions of time to maturity, as opposed to the twisting curves one gets from the traditional method, and are less sensitive to model specifications. Moreover, the implied corporate term structures have tighter confidence bands. The credit spreads and term structures that result from the framework are therefore more suited to be used as input to, e.g., models that asses the credit risk in derivatives, pricing models for credit derivatives and corporate bonds, risk management procedures, and time series analyses of credit spreads.

Abstract:
We consider eight different proxies (issued amount, coupon, listed, age, missing prices, yield volatility, number of contributors and yield dispersion) to measure corporate bond liquidity and use a five-variable model to control for interest rate risk, credit risk, maturity, rating and currency differences between bonds. The null hypothesis that liquidity risk is not priced in our data set of euro corporate bonds is rejected for seven out of eight liquidity proxies. We find significant liquidity premia, ranging from 9 to 24 basis points. A comparison test between liquidity proxies shows limited differences between the proxies.

liquidity, premiums, spreads, credit, corporate bonds, yields, fama-french model

Abstract:
The paper proposes a new measure of spread exposure for corporate bonds portfolios based on a detailed analysis of credit spread behavior. We find that changes in spreads are not parallel but rather linearly proportional to the level of spread, whereby bonds trading at wider spreads experience larger spread changes. Consequently, systematic spread volatility of a sector is proportional to its spread; similarly, the idiosyncratic spread volatility of a particular bond or issuer is proportional to its spread, irrespective of sector, maturity and time period. We confirm that the behavior of spreads results in excess return volatility being proportional to Duration Times Spread (DTS). We demonstrate the advantage of DTS over spread-duration in predicting future excess return volatility, index replication and portfolio construction and discuss the implications of our findings for the formulation of investment constraints, asset allocation, risk modeling and performance attribution.

credit risk, corporate bonds

Abstract:
We value rating-triggered step-up bonds with three methods: (i) the Jarrow, Lando and Turnbull [1997, JLT] framework, (ii) a similar framework using historical probabilities and (iii) as plain vanilla bonds. We find that the market seems to value single step-up bonds according to the JLT model, while it values multiple step-up bonds as plain vanilla bonds. Further, step-up feature market premiums are more volatile than JLT and historical premiums, and the JLT model approximates market premiums always better than the historical method. Finally, most step-up bonds offer a cushion against rating migrations via dampened price movements.

step-up bonds, rating-triggered, credit risk, reduced form models, Jarrow Lando Turnbull

Abstract:
Abstract: In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model with a constant recovery rate outperforms the market practice of directly comparing bonds' credit spreads to default swap premiums. We find that the model works well for investment grade credit default swaps, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is insensitive to the value of the assumed recovery rate. Keywords: credit default swaps, credit derivatives, credit risk, default risk, default-free interest rates

credit default swaps, credit derivatives, credit risk, default risk, default-free interest rates, market prices, empirical models