Macroeconomic Conditions, Firm Characteristics, and Credit Spreads
Dragon Yongjun Tang
University of Hong Kong - School of Economics and Finance
University of South Carolina; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)
March 15, 2005
We study a structural model that allows us to examine how credit spreads are affected by the interaction of macroeconomic conditions and firm characteristics. Unlike most other structural models, our model explicitly incorporates equilibrium macroeconomic dynamics and models a firm's cash flow as primitive processes. Corporate securities are priced as contingent claims written on cash flows. Default occurs when the firm's cash flow cannot cover the interest payments and the recovery rate is dependent on the economic condition at default. Our model produces the following predictions: (i) credit spread is negatively correlated with interest rate and, ceteris paribus, this correlation is stronger for bonds with higher default probabilities; (ii) credit spread yield curves are upward sloping for low-grade bonds; (iii) firm characteristics other than leverage ratios have significant effects on credit spreads and these effects also vary with economic conditions. These predictions are consistent with the available empirical evidence and generate implications for further empirical investigation.
Number of Pages in PDF File: 49
Keywords: Default Risk, Macroeconomic Conditions, Credit Spread
JEL Classification: G12, G13, E43, E44working papers series
Date posted: March 23, 2005
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