Modelling credit spreads on yen Eurobonds within an equilibrium correction framework

Seppo Pynnönen*, Warren P. Hogan, Jonathan A. Batten

*Corresponding author for this work

Research output: Contribution to journalArticle

3 Citations (Scopus)

Abstract

This study develops an equilibrium correction model (ECM) of the credit spreads on quality Japanese yen Eurobonds based on the Longstaff and Schwartz (1995) continuous time, closed form solution of the arbitrage-free value on risky debt. The solution predicts testable relationships between the credit spread and several important factors involved, including the risk-free interest rate, firm asset volatility, and the firm asset return correlation with changes in the risk-free rate. In the frictionless continuous time approach a key assumption is that the markets adjust without delays to the new equilibrium. In reality, however, adjustments take time, such that the markets may be temporally out of the equilibrium. The results of this study show that unlike other findings from the USA, Japanese spreads are stationary. Accordingly, an implied equilibrium correction procedure is incorporated into the modelling process. While traditional theories of credit-spread behaviour predict that changes in the risk free interest rate and asset factors are negatively correlated with changes in credit spreads on risky bonds, it is found that the asset factor, as proxied by the change in the stock market index, has only a very limited effect, whereas the interest rate factor has the over-riding influence both in the long and short run. Furthermore, whereas an increase in asset volatility should have an increasing effect on the credit spread, it is found that the prevailing spread change volatility has a more pronounced effect. There is also evidence that changes in the term structure affects both the long run equilibrium as well as the short run changes in the spread. Furthermore, the asset return correlation with the risk free rate receives empirical support to affect the credit spread in the manner predicted by the Longstaff and Schwartz (1995) theoretical model.

Original languageEnglish
Pages (from-to)583-606
Number of pages24
JournalApplied Financial Economics
Volume16
Issue number8
DOIs
Publication statusPublished - 1 May 2006

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