Macroeconomic Conditions, Firm Characteristics, and Credit Spreads
49 Pages Posted: 23 Mar 2005
Date Written: March 15, 2005
We study a structural model that allows us to examine how credit spreads are affected by the interaction of macroeconomic conditions and firm characteristics. Unlike most other structural models, our model explicitly incorporates equilibrium macroeconomic dynamics and models a firm's cash flow as primitive processes. Corporate securities are priced as contingent claims written on cash flows. Default occurs when the firm's cash flow cannot cover the interest payments and the recovery rate is dependent on the economic condition at default. Our model produces the following predictions: (i) credit spread is negatively correlated with interest rate and, ceteris paribus, this correlation is stronger for bonds with higher default probabilities; (ii) credit spread yield curves are upward sloping for low-grade bonds; (iii) firm characteristics other than leverage ratios have significant effects on credit spreads and these effects also vary with economic conditions. These predictions are consistent with the available empirical evidence and generate implications for further empirical investigation.
Keywords: Default Risk, Macroeconomic Conditions, Credit Spread
JEL Classification: G12, G13, E43, E44
Suggested Citation: Suggested Citation