FIN-03-012 |
NYU Stern School of Business |
March 2003
Herman Bierens, Jing-zhi Huang and Weipeng Kong
ABSTRACT
In this paper, we examine the dynamic behavior of credit spreads on corporate bond
portfolios. We propose an economeic model of credit spreads that incorporates portfolio
rebalancing, the near unit root property of spreads, the autocorrelation in spread changes,
the ARCH conditional heteroscedasticity, jumps, and lagged market factors. In particular,
our model is the first that takes into account explicitly the impact of rebalancing and yields
estimates of the absorbing bounds on credit spreads induced by such rebalancing. We
apply our model to nine Merrill Lynch daily series of option-adjusted spreads with ratings
from AAA to C for the period January, 1997 through August, 2002. We find no evidence
of mean reversion in these credit spread series over our sample period. However, we find
ample evidence of both the ARCH effect and jumps in the data especially in the investment-grade
credit spread indices. Incorporating jumps into the ARCH type conditional variance
results in significant improvements in model diagnostic tests. We also find that while log
spread variations depend on both the lagged Russell 2000 index return and lagged changes
in the slope of the yield curve, the time-varying jump intensity of log credit spreads is
correlated with the lagged stock market volatility. Finally, our results indicate the ARCH-jump
specification outperforms the ARCH specification in the out-of-sample, one-step-ahead
forecast of credit spreads.
Herman Bierens
Institution: Department of Economics, Penn State University, University Park, PA 16802
Telephone: (814) 865-4921
Email: hbierens@psu.edu
Jing-zhi Huang
Institution: Stern School of Business, New York University, 44 West 4th Seet, New York, NY 10012
Telephone: (212) 998-0300
Fax: (212) 995-4233
Email: jhuang0@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~jhuang0
Weipeng Kong
Institution: Smeal College of Business, Pennsylvania State University, University Park, PA 16802
Telephone: (814) 865-0618
Email: wxk140@psu.edu
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