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Stock Market Performance and the Term Structure of Credit Spreads

Published online by Cambridge University Press:  06 April 2009

Andriy Demchuk  and
Rajna Gibson
Andriy Demchuk
Affiliation:
ad@fame.ch, NCCR-FINRISK and FAME, University of Zürich, and Gibson
Rajna Gibson
Affiliation:
rgibson@isb.unizh.ch, Swiss Banking Institute, University of Zürich, Plattenstrasse 14, 8032 Zürich, Switzerland.
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Abstract

We build a structural two-factor model of default where the stock market index is one of the stochastic factors. We allow the firm to adjust its leverage ratio in response to changes in the business climate for which the past performance of the stock market index acts as a proxy. We assume that the firm's log-leverage ratio follows a mean-reverting process and that the past performance of the stock index negatively affects the firms target leverage ratio. We show that for most credit ratings our model may explain actual yield spreads better than other well-known structural credit risk models. Also, our model shows that the past performance of the stock index returns and the firm's assets beta have a significant impact on credit spreads. Hence, our model can explain why credit spreads may be different within the same credit rating groups and why spreads are lower during economic expansions and higher during recessions.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 41 , Issue 4 , December 2006 , pp. 863 - 887
Copyright
Copyright © School of Business Administration, University of Washington 2006

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