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Dynamical Analysis of Corporate Bonds based on the Yield Spread Term-Quality Surface

by Tomoaki Shouda of Mitsubishi UFJ Trust Investment Technology Institute Co., Ltd & Hitotsubashi University

January 16, 2006

Abstract: Our aim of this research is to propose a model which estimates implied relative credit reliability from the yield spread of defaultable bonds and evaluates their spread risk. We introduce \Yield Spread Term-Quality Surface" (YSTQS) which is defined on the space of duration and credit reliability of the issuers, and express their yield spread. First, we review the general pricing theorem of defaultable bonds with unpredictable recovery in the no-arbitrage context based on the external hazard rates. Second, we show that the dynamics of state variables determine the shape of the YSTQS, and they drive the YSTQS if the loss-adjusted hazard rates are described by a function of them. Finally, we show an empirical analysis of our model with daily yield spread, duration, and the credit ratings of corporate bonds.

JEL Classification: C32, C33, C51, G33.

Keywords: Default risk, Hazard rate, Yield spread surface, Credit quality, Spread risk, Markov state variable, No-arbitrage.

Published in: Asia-Pacific Financial Markets, Vol. 12, No. 4, (December 2005), pp. 307-332.

Previously titled: Dynamical Analysis of the Yield Spread Surface Defined on the Duration - Credit Quality Space

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