Are Credit Spreads Too Low or Too High - A Hybrid Barrier Option Approach for Financial Distress

Journal of Futures Markets, Vol. 29, No. 12, pp. 1161-1189, 2009

Posted: 25 Jan 2010

See all articles by William T. LIn

William T. LIn

Tamkang University - Banking & Finance

David S. Sun

Kainan University

Date Written: April 20, 2009

Abstract

Based on the works of Brockman and Turtle (2003) and Giesecke (2004), we propose in this study a hybrid barrier option model to explain observed credit spreads. It is free of problems with the structural model which underprescribed credit spreads for investment grade corporate bonds and overprescribed the high yield issues. Unlike the standard barrier option approach, our hybrid model does not imply, for high yield issues with firms under financial stress, a reduction of credit spreads while firm value actually falls. Our empirical analysis supports that when credit spreads are quoted abnormally higher or rising faster than expected, unexpected changes tend to persist. Otherwise a significant and prompt reversion to long term equilibrium takes place. This asymmetric pricing phenomenon is validated with a method introduced by Enders and Granger (1998) and Enders and Siklos (2001). The pricing asymmetry could not have been produced by a structural model employing only standard option. But it is consistent with a hybrid barrier option model. Our model characterizes the valuation of debt under financial stress and the asymmetric price pattern better than both the classical structural and the standard barrier option approaches. It can be extended to the study of individual CDS for its better liquidity than individual corporate bonds. This study provides helpful implications especially for the medium and high yield issues in pricing as well as portfolio diversification.

Keywords: Asymmetric threshold cointegration, barrier option, credit risk, diversifiable risk

JEL Classification: C32, C52, G13, G33

Suggested Citation

LIn, William T. and Sun, David S., Are Credit Spreads Too Low or Too High - A Hybrid Barrier Option Approach for Financial Distress (April 20, 2009). Journal of Futures Markets, Vol. 29, No. 12, pp. 1161-1189, 2009, Available at SSRN: https://ssrn.com/abstract=1540924

William T. LIn

Tamkang University - Banking & Finance ( email )

Department of Banking and Finance
Taiwan, 25137
Taiwan

David S. Sun (Contact Author)

Kainan University ( email )

No. 1, Kāinán Rd
Taoyuan, Taiwan
Taiwan

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