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Credit Risk and Market Risk: Analyzing US Credit Spreads

by Hayette Gatfaoui of the Rouen School of Management

August 2006

Abstract: We attempt to disentangle US credit spreads' evolution into a part resulting from market risk influence and a part resulting from default risk influence. We consider two kinds of data, namely credit spreads (versus Treasury yields) as a proxy of credit risk and S&P 500 stock index as a proxy of market/systematic risk. Such data allow for achieving a sensitivity study of credit risk to systematic risk relative to sector, credit rating and maturity risk levels. First, we extract the common unobserved component of credit risk (i.e., common latent factor) from observed credit spread data in the light of three risk dimensions, namely credit rating, maturity and industry. We exhibit then the sensitivity of credit risk to market risk according to three different risk levels, namely the three risk dimensions previously mentioned. Second, we investigate the link prevailing between the common latent factor and S&P 500 stock index along with those three risk dimensions. We exhibit therefore the link prevailing between the systematic component of credit spreads (i.e., credit risk) and S&P 500 index as a proxy of market risk factor. We find that employing S&P 500 stock index as a proxy of the systematic risk component in US credit spreads generates a valuation bias while assessing credit risk.

JEL Classification: C32, C51, G1.

Keywords: Credit spreads, Credit risk, Flexible least squares, Kalman filter, Latent factor, Market risk, Systematic risk.

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