A No-Arbitrage Analysis of Macroeconomic Determinants of the Credit Spread Term Structure

Abstract

F rom a large array of economic and financial data series, this paper identifies three fundamental risk dimensions underlying an economy: inflation, real output growth, and financial market volatility. Furthermore, through a no-arbitrage model, the paper links the dynamics and market pricing of the three risk dimensions to the term structure of U.S. Treasury yields and corporate bond credit spreads. Model estimation shows that positive inflation shocks increase Treasury yields and widen credit spreads on corporate bonds across all maturities and credit-rating classes. Positive real output growth shocks also increase Treasury yields, but they suppress the credit spreads at low credit-rating classes, thus generating negative correlations between interest rates and credit spreads. The financial market volatility factor has a small and transient effect on the Treasury yield curve, but it exerts a strongly positive and persistent effect on the credit spread term structure. The paper provides a robust and internally consistent method for extracting systematic economic information from a large array of noisy observations and establishing how different risk dimensions of the fundamental economy interact with interest rate and credit risk.

Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

“…Pan and Singleton (2008) explore the nature of the default arrival and recovery/loss implicit in the term structure of sovereign CDS spreads and find positive evidence for informational efficiency and the close linkage between the unpredictable component of the credit events and the measures of global risk aversion, financial market volatility, and macroeconomic policy. Wu and Zhang (2008) reveal the determinants of the term structure of the credit spreads (both sovereign and corporate), such as macroeconomic fundamental and financial market volatility. Positive inflation and real output growth shocks increases the sovereign spreads.…”

“…The investigation is well based on the theory of a country's external adjustment to the global imbalances through the valuation channel of exchange rates (Gourinchas and Rey, 2007;Caballero, Farhi, and Gourinchas, 2008). Global imbalances are believed to be the crucial macroeconomic determinant of sovereign credit risk (Baek, Bandopadhyaya, and Du, 2005;Wu and Zhang, 2008;Hilscher and Nosbusch, 2010;Durdu, Mendoza, and Terrones, 2013) and therefore are priced in the term structure of sovereign CDS spreads (Pan and Singleton, 2008;Longstaff, Pan, Pedersen, and Singleton, 2011). Following this economic logic, I link the implicit sovereign default and recovery closely to the term structure of interest rates (Cox, Ingersoll, and Ross, 1985) to explain the forward premium anomalies (Backus, Foresi, and Telmer, 2001;Bekaert, Wei, and Xing, 2007;Ang and Chen, 2010).…”

Accounting-based versus market-based cross-sectional models of CDS spreads

“…Ang and Patel, 1975;Kaplan and Urwitz, 1979;Blume et al, 1998), or bond spreads (e.g. Wu and Zhang, 2004;Huang and Kong, 2005;Collin-Dufresne et al, 2001;Longstaff and Rajan, 2006). First, CDS spreads offer cross-sectional and time-series credit quality information.…”

Theory and evidence on the dynamic interactions between sovereign credit default swaps and currency options

“…See for example,Bevan and Garzarelli (2000),Frye (2000),Pedrosa and Roll (1998), Collin-Dufresne et al (2001), Aunon-Nerin et al (2002), Bangia et al (2002), Altman et al (2005), Bakshi et al (2006), Ericsson et al (2004),Carr and Wu (2005) andWu and Zhang (2005).3 In this article, we adopt the viewpoint of a US investor without loss of generality. Investors based in other countries can substitute their currency for the dollar.…”