Credit Risk and the Transmission of Interest Rate Shocks

70 Pages Posted: 7 Dec 2020

See all articles by Berardino Palazzo

Berardino Palazzo

Board of Governors of the Federal Reserve System

Ram Yamarthy

Office of Financial Research, US Department of the Treasury

Multiple version iconThere are 2 versions of this paper

Date Written: December 3, 2020

Abstract

Using daily credit default swap (CDS) data going back to the early 2000s, we find a positive and significant relation between corporate credit risk and unexpected interest rate shocks around FOMC announcement days. Positive interest rate movements increase the expected loss component of CDS spreads as well as a risk premium component that captures compensation for default risk. Not all firms respond in the same manner. Consistent with recent evidence, we find that firm-level credit risk (as proxied by the CDS spread) is an important driver of the response to monetary policy shocks – both in credit and equity markets – and plays a more prominent role in determining monetary policy sensitivity than other common proxies of firm-level risk such as leverage and market size. A stylized corporate model of monetary policy, firm investment, and financing decisions rationalizes our findings.

Keywords: credit risk, CDS, monetary policy, shock transmission, equity returns

JEL Classification: E52, G12, G18, G32

Suggested Citation

Palazzo, Berardino and Yamarthy, Ram, Credit Risk and the Transmission of Interest Rate Shocks (December 3, 2020). OFR 20-05, Available at SSRN: https://ssrn.com/abstract=3742152 or http://dx.doi.org/10.2139/ssrn.3742152

Berardino Palazzo

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ram Yamarthy (Contact Author)

Office of Financial Research, US Department of the Treasury ( email )

717 14th Street, NW
Washington, DC 20220
United States

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