Credit Spreads and State-Dependent Volatility: Theory and Empirical Evidence

61 Pages Posted: 27 Mar 2014 Last revised: 3 May 2017

See all articles by Stylianos Perrakis

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business

Rui Zhong

The University of Western Australia - UWA Business School

Date Written: January 30, 2014

Abstract

We generalize the asset dynamics assumptions of Leland (1994b) and Leland and Toft (1996) to a much richer class of models. By assuming a stationary corporate debt structure with constant principal, coupon payment and average maturity through continuous retirement and refinancing as long as the firm remains solvent, we obtain analytical solutions with the state dependent diffusion volatility following the constant elasticity of variance (CEV) process for the variables of interest, including corporate debt value, total levered firm value and equity value. We then apply our derivations to time-series data extracted from a sample of firms, extract the models’ parameters and compare the performance of our CEV model to the constant volatility (zero elasticity) assumption of earlier studies. We find that the elasticity is significantly different from zero for most of the firms in our sample, and that the CEV model performs much better than constant volatility in predicting CDS spreads, especially with respect to the medium and long-term spreads.

Keywords: Credit default swaps, credit risk, constant elasticity of variance, structural model

JEL Classification: G12, G13, G32, G33

Suggested Citation

Perrakis, Stylianos and Zhong, Rui, Credit Spreads and State-Dependent Volatility: Theory and Empirical Evidence (January 30, 2014). Journal of Banking and Finance, Vol. 55, 2015. Available at SSRN: https://ssrn.com/abstract=2414621 or http://dx.doi.org/10.2139/ssrn.2414621

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business ( email )

1455 de Maisonneuve Blvd. W.
Montreal, Quebec H3G 1M8
Canada

Rui Zhong (Contact Author)

The University of Western Australia - UWA Business School ( email )

35 Stirling Highway
Crawley, Western Australia 6009
Australia

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