Abstract

http://ssrn.com/abstract=779445
 
 

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Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads


Ren-Raw Chen


Fordham University Schools of Business

Xiaolin Cheng


Rutgers Business School - New Brunswick

Liuren Wu


City University of New York, CUNY Baruch College - Zicklin School of Business



Abstract:     
Using a large data set on credit default swaps, we study how default risk interacts with interest-rate risk and liquidity risk to jointly determine the term structure of credit spreads. We classify the reference companies into two broad industry sectors, two broad credit rating classes, and two liquidity groups. We develop a class of dynamic term structure models that include (i) two benchmark interest-rate factors to capture the libor and swap rates term structure, (ii) two credit-risk factors to capture the credit swap spreads of high-liquidity group of each industry and rating class, and (iii) both an additional credit-risk factor and a liquidity-risk factor to capture the difference between the high- and low-liquidity groups. Estimation shows that companies in different industry and credit rating classes have different credit-risk dynamics. Nevertheless, in all cases, credit risks exhibit intricate dynamic interactions with the interest-rate factors. Interest-rate factors both affect credit spreads simultaneously, and impact subsequent moves in the credit-risk factors. Within each industry and credit rating class, we also find that the average credit default swap spreads for the high-liquidity group are significantly higher than for the low-liquidity group. Estimation shows that the difference is driven by both credit risk and liquidity differences. The low-liquidity group has a lower default arrival rate and also a much heavier discounting induced by the liquidity risk.

Number of Pages in PDF File: 50

Keywords: Credit default swap, credit risk, credit premium, term structure, interest rate risk, liquidity risk, liquidity premium, maximum likelihood estimation.

JEL Classification: E43, G12, G13, C51.

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Date posted: August 16, 2005  

Suggested Citation

Chen, Ren-Raw and Cheng, Xiaolin and Wu, Liuren, Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads. Available at SSRN: http://ssrn.com/abstract=779445 or http://dx.doi.org/10.2139/ssrn.779445

Contact Information

Ren-Raw Chen
Fordham University Schools of Business ( email )
113 West 60th Street
Bronx, NY 10458
United States

Xiaolin Cheng
Rutgers Business School - New Brunswick ( email )
94 Rockafeller Road
New Brunswick, NJ 08901
United States
Liuren Wu (Contact Author)
City University of New York, CUNY Baruch College - Zicklin School of Business ( email )
One Bernard Baruch Way
Box B10-225
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)
HOME PAGE: http://faculty.baruch.cuny.edu/lwu/
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