Modelling credit spreads on yen Eurobonds within an equilibrium correction framework

Pynnönen, S; Hogan, WP; Batten, JA

Modelling credit spreads on yen Eurobonds within an equilibrium correction framework

Pynnönen, S Hogan, WP Batten, JA

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Publication Type:: Journal Article
Citation:: Applied Financial Economics, 2006, 16 (8), pp. 583 - 606
Issue Date:: 2006-05-01

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Field	Value	Language
dc.contributor.author	Pynnönen, S	en_US
dc.contributor.author	Hogan, WP	en_US
dc.contributor.author	Batten, JA	en_US
dc.date.issued	2006-05-01	en_US
dc.identifier.citation	Applied Financial Economics, 2006, 16 (8), pp. 583 - 606	en_US
dc.identifier.issn	0960-3107	en_US
dc.identifier.uri	http://hdl.handle.net/10453/5060
dc.description.abstract	This study develops an equilibrium correction model (ECM) of the credit spreads on quality Japanese yen Eurobonds based on the Longstaff and Schwartz (1995) continuous time, closed form solution of the arbitrage-free value on risky debt. The solution predicts testable relationships between the credit spread and several important factors involved, including the risk-free interest rate, firm asset volatility, and the firm asset return correlation with changes in the risk-free rate. In the frictionless continuous time approach a key assumption is that the markets adjust without delays to the new equilibrium. In reality, however, adjustments take time, such that the markets may be temporally out of the equilibrium. The results of this study show that unlike other findings from the USA, Japanese spreads are stationary. Accordingly, an implied equilibrium correction procedure is incorporated into the modelling process. While traditional theories of credit-spread behaviour predict that changes in the risk free interest rate and asset factors are negatively correlated with changes in credit spreads on risky bonds, it is found that the asset factor, as proxied by the change in the stock market index, has only a very limited effect, whereas the interest rate factor has the over-riding influence both in the long and short run. Furthermore, whereas an increase in asset volatility should have an increasing effect on the credit spread, it is found that the prevailing spread change volatility has a more pronounced effect. There is also evidence that changes in the term structure affects both the long run equilibrium as well as the short run changes in the spread. Furthermore, the asset return correlation with the risk free rate receives empirical support to affect the credit spread in the manner predicted by the Longstaff and Schwartz (1995) theoretical model. © 2006 Taylor & Francis.	en_US
dc.relation.ispartof	Applied Financial Economics	en_US
dc.relation.isbasedon	10.1080/09603100600684740	en_US
dc.subject.classification	Finance	en_US
dc.title	Modelling credit spreads on yen Eurobonds within an equilibrium correction framework	en_US
dc.type	Journal Article
utslib.citation.volume	8	en_US
utslib.citation.volume	16	en_US
utslib.for	1402 Applied Economics	en_US
utslib.for	1502 Banking, Finance and Investment	en_US
pubs.embargo.period	Not known	en_US
pubs.organisational-group	/University of Technology Sydney
pubs.organisational-group	/University of Technology Sydney/Faculty of Business
utslib.copyright.status	closed_access
pubs.issue	8	en_US
pubs.publication-status	Published	en_US
pubs.volume	16	en_US

Abstract:

This study develops an equilibrium correction model (ECM) of the credit spreads on quality Japanese yen Eurobonds based on the Longstaff and Schwartz (1995) continuous time, closed form solution of the arbitrage-free value on risky debt. The solution predicts testable relationships between the credit spread and several important factors involved, including the risk-free interest rate, firm asset volatility, and the firm asset return correlation with changes in the risk-free rate. In the frictionless continuous time approach a key assumption is that the markets adjust without delays to the new equilibrium. In reality, however, adjustments take time, such that the markets may be temporally out of the equilibrium. The results of this study show that unlike other findings from the USA, Japanese spreads are stationary. Accordingly, an implied equilibrium correction procedure is incorporated into the modelling process. While traditional theories of credit-spread behaviour predict that changes in the risk free interest rate and asset factors are negatively correlated with changes in credit spreads on risky bonds, it is found that the asset factor, as proxied by the change in the stock market index, has only a very limited effect, whereas the interest rate factor has the over-riding influence both in the long and short run. Furthermore, whereas an increase in asset volatility should have an increasing effect on the credit spread, it is found that the prevailing spread change volatility has a more pronounced effect. There is also evidence that changes in the term structure affects both the long run equilibrium as well as the short run changes in the spread. Furthermore, the asset return correlation with the risk free rate receives empirical support to affect the credit spread in the manner predicted by the Longstaff and Schwartz (1995) theoretical model. © 2006 Taylor & Francis.

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http://hdl.handle.net/10453/5060