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Modeling the Dynamics of Credit Spreads with Stochastic Volatility

by Kris Jacobs of McGill University, and
Xiaofei Li of York University

January 2004

Abstract: This paper investigates a two-factor affine model for the credit spreads on corporate bonds. The first factor can be interpreted as the level of the spread, and the second factor is the volatility of the spread. The riskless interest rate is modeled using a standard two-factor affine model, thus leading to a four-factor model for corporate yields. This approach allows us to model the volatility of corporate credit spreads as stochastic, and also allows us to capture higher moments of credit spreads. We use an extended Kalman filter approach to estimate our model on corporate bond prices for 108 firms. The model is found to be successful at fitting actual corporate bond credit spreads, resulting in a significantly lower root mean square error (RMSE) than a standard alternative model in both in-sample and out-of-sample analyses. In addition, key properties of actual credit spreads are better captured by the model.

JEL Classification: G12.

Keywords: credit risk, credit spreads, reduced form models, stochastic volatility.

Published in: Management Science, Vol. 54, No. 6, (June 2008), pp. 1176-1188.

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