Exploring Common Factors in the Term Structure of Credit Spreads: The Use of Canonical Correlations

49 Pages Posted: 8 May 2007 Last revised: 31 Aug 2012

See all articles by Seung C. Ahn

Seung C. Ahn

Arizona State University (ASU) - Economics Department

Stephan Dieckmann

University of Pennsylvania - Finance Department

Marcos Fabricio Perez

Wilfrid Laurier University - School of Business & Economics

Date Written: August 28, 2012

Abstract

This paper provides a new approach to model the common variation in the term structure of credit spreads. The novelty is that common factors are extracted using canonical relations between credit spreads and observable economic variables. We show how these factors can be used to test if a given set of macroeconomic and financial variables is sufficient to capture all the systematic variation in response variables, such as credit spreads. We find that credit spread innovations are subject to three common factors, two strong factors and one weak factor, and they account for 49% of the total variation. The first strong factor is related to the contemporaneous state of the economy, the second represents expectations about future economic conditions, and the weak factor is mainly related to the error correction processes in short-term spreads.

Keywords: Factor Analysis, Credit Risk, Common Factors, Canonical Correlations

JEL Classification: C33, G12

Suggested Citation

Ahn, Seung C. and Dieckmann, Stephan and Perez, Marcos Fabricio, Exploring Common Factors in the Term Structure of Credit Spreads: The Use of Canonical Correlations (August 28, 2012). Available at SSRN: https://ssrn.com/abstract=984245 or http://dx.doi.org/10.2139/ssrn.984245

Seung C. Ahn

Arizona State University (ASU) - Economics Department ( email )

Tempe, AZ 85287-3806
United States

Stephan Dieckmann (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Marcos Fabricio Perez

Wilfrid Laurier University - School of Business & Economics ( email )

Waterloo, Ontario N2L 3C5
CANADA
519-884 0710 (Phone)
519-884 0201 (Fax)

HOME PAGE: http://www.public.asu.edu/~mfperez/

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