An Empirical Investigation in Credit Spread Indices
by Jean-Luc Prigent of the Université de Cergy-Pontoise,
Abstract: We study the dynamics of the spread between U.S. corporate and Treasury bonds. We focus on Aaa and Baa corporate yield indices and estimate nonparametrically the dynamics of the spreads assuming that they follow a univariate diffusion process. Using techniques developed for interest rate processes we try to infer from the data what acceptable process can be used to model aggregate credit spreads for option pricing or risk management purposes. We find that there is significant evidence of mean reversion especially for higher rated spreads and that the volatility of Aaa spreads exhibit a U-shape while the volatility of Baa spreads is monotonically increasing in the level of spreads. Based on these observations and on the evidence of jumps in the series, we propose a new model for credit spread indices (an Ornstein-Uhlenbeck with jumps) and estimate it by maximum likelihood.
Keywords: credit spread, risk management, jump diffusion, volatility, nonparametric.
Published in: Journal of Risk, Vol. 3, No. 1, (Fall 2001), pp. 27-55.