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The Dynamics of Credit Spreads and Ratings Migrations

Published online by Cambridge University Press:  06 April 2009

Heber Farnsworth  and
Tao Li
Heber Farnsworth
Affiliation:
heber.farnsworth@nisanet.com, NISA Investment Advisors, LLC, 150 N. Meramec Ave., Suite 640, St. Louis, MO 63105
Tao Li
Affiliation:
litao@cuhk.edu.hk, Chinese University of Hong Kong, Faculty of Business Administration, Department of Finance, Shatin, Hong Kong.
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Abstract

There is a large and growing literature on how to model the dynamics of the default-free term structure to fit the observed historical data. Much less is known about how best to model the dynamics of defaultable yield curves. This paper develops a class of defaultable term structure models that is tractable enough to be empirically implemented and flexible enough to capture some important behaviors of the credit spreads in the data. We compare two non-nested models within this class using a Bayesian estimation technique, which helps to solve the problem of latent state variables. The Bayesian approach also enables us to test the two non-nested models on the basis of the Bayes factor. The results strongly suggest that models with constant transition probabilities will not be able to fit the observed dynamics of inter-rating spreads.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 42 , Issue 3 , September 2007 , pp. 595 - 620
Copyright
Copyright © School of Business Administration, University of Washington 2007

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