Exploring Common Factors in the Term Structure of Credit Spreads: The Use of Canonical Correlations
Seung C. Ahn
Arizona State University (ASU) - Economics Department
University of Pennsylvania - Finance Department
Marcos Fabricio Perez
Wilfrid Laurier University - School of Business & Economics
August 28, 2012
This paper provides a new approach to model the common variation in the term structure of credit spreads. The novelty is that common factors are extracted using canonical relations between credit spreads and observable economic variables. We show how these factors can be used to test if a given set of macroeconomic and financial variables is sufficient to capture all the systematic variation in response variables, such as credit spreads. We find that credit spread innovations are subject to three common factors, two strong factors and one weak factor, and they account for 49% of the total variation. The first strong factor is related to the contemporaneous state of the economy, the second represents expectations about future economic conditions, and the weak factor is mainly related to the error correction processes in short-term spreads.
Number of Pages in PDF File: 49
Keywords: Factor Analysis, Credit Risk, Common Factors, Canonical Correlations
JEL Classification: C33, G12working papers series
Date posted: May 8, 2007 ; Last revised: August 31, 2012
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