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A No-Arbitrage Analysis of Economic Determinants of the Credit Spread Term Structure


Liuren Wu


City University of New York, CUNY Baruch College - Zicklin School of Business

Frank Xiaoling Zhang


Morgan Stanley

December 2005

FEDS Discussion Paper No. 2005-59
Management Science, Forthcoming

Abstract:     
This paper presents an internally consistent analysis of the economic determinants of the term structure of credit spreads across different credit rating classes and industry sectors. Our analysis proceeds in two steps. First, we extract three economic factors from 13 time series that capture three major dimensions of the economy: inflation pressure, real output growth, and financial market volatility. In the second step, we build a no-arbitrage model that links the dynamics and market prices of these fundamental sources of economic risks to the term structure of Treasury yields and corporate bond credit spreads. Via model estimation, we infer the market pricing of these economic factors and their impacts on the whole term structure of Treasury yields and credit spreads.

Estimation shows that positive inflation shocks increase both Treasury yields and credit spreads across all maturities and credit rating classes. Positive shocks on the real output growth also increase the Treasury yields, more so at short maturities than at long maturities. The impacts on the credit spreads are positive for high credit rating classes, but become negative and increasingly so at lower credit rating classes. The financial market volatility factor has small positive impacts on the Treasury yield curve, but the impacts are strongly positive on the credit spreads, and increasingly so at longer maturities and lower credit rating classes.

Finally, when we divide each rating class into two industry sectors: financial and corporate, we find that with in each rating class, the credit spreads in the financial sector are on average wider and more volatile than the spreads in the corporate sector. Estimation further shows that the term structure of credit spreads in the financial sector is more responsive to shocks in the economic factors.

Number of Pages in PDF File: 33

Keywords: Credit spreads, term structure, interest rates, macroeconomic factors, financial leverage, volatility, dynamic factor mode, Kalman filter

JEL Classification: E43, G12, G13

Accepted Paper Series


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Date posted: March 21, 2005 ; Last revised: June 15, 2008

Suggested Citation

Wu, Liuren and Zhang, Frank Xiaoling, A No-Arbitrage Analysis of Economic Determinants of the Credit Spread Term Structure (December 2005). FEDS Discussion Paper No. 2005-59; Management Science, Forthcoming. Available at SSRN: http://ssrn.com/abstract=686945

Contact Information

Liuren Wu (Contact Author)
City University of New York, CUNY Baruch College - Zicklin School of Business ( email )
One Bernard Baruch Way
Box B10-225
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)
HOME PAGE: http://faculty.baruch.cuny.edu/lwu/
Frank Xiaoling Zhang
Morgan Stanley ( email )
1585 Broadway
New York, NY 10036
United States
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