Credit Spreads, Leverage and Volatility: a Cointegration Approach

34 Pages Posted: 8 May 2020

Date Written: April 14, 2020

Abstract

This work documents the existence of a cointegration relationship between credit spreads, leverage and equity volatility for a large set of US companies. It is shown that accounting for the long-run equilibrium dynamic between these variables is essential to correctly explain credit spread changes. Using a novel structural model in which equity is modelled as a compound option on the firm's assets, a new methodology for estimating the unobservable market value of the firm's assets and volatility is developed. The proposed model allows to significantly reduce the pricing errors in predicting credit spreads when compared with several structural models. In terms of correlation analysis, it is shown that not accounting for the long-run equilibrium equation embedded in an Error Correction Mechanism (ECM) results into a misspesification problem when regressing a set of explanatory variables onto the spread changes. Once credit spreads, leverage and volatility are correctly modelled, thus allowing for a long-run equilibrium, the fit of the regressions sensibly increases if compared to the results of previous research. It is further shown that most of the cross-sectional variation of the spreads appears to be more driven by firm-specific characteristics rather than systematic factors.

Keywords: credit spreads, financial leverage, asset volatility, cointegration, compound options

JEL Classification: C58, C61, G13, G32, G33

Suggested Citation

Maglione, Federico, Credit Spreads, Leverage and Volatility: a Cointegration Approach (April 14, 2020). Available at SSRN: https://ssrn.com/abstract=3575545 or http://dx.doi.org/10.2139/ssrn.3575545

Federico Maglione (Contact Author)

Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

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