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Modeling the Dynamics of Credit Spreads with Stochastic Volatility

Faculty of Management, McGill University, Montreal, Quebec H3A 1G5, Canada, and Tilburg University, Tilburg, The Netherlands
School of Administrative Studies, York University, Toronto, Ontario M3J 1P3, Canada
kris.jacobs{at}mcgill.ca
xiaofeil{at}yorku.ca

This paper investigates a two-factor affine model for the credit spreads on corporate bonds. The first factor can be interpreted as the level of the spread and the second factor is the volatility of the spread. The riskless interest rate is modeled using a standard two-factor affine model, thus leading to a four-factor model for corporate yields. This approach allows us to model the volatility of corporate credit spreads as stochastic, and also allows us to capture higher moments of credit spreads. We use an extended Kalman filter approach to estimate our model on corporate bond prices for 108 firms. The model is found to be successful at fitting actual corporate bond credit spreads, resulting in a significantly lower root mean square error than a standard alternative model both in sample and out of sample. In addition, key properties of actual credit spreads such as the stochastic volatility of the credit spreads and the positive skewness of the credit spread distribution are better captured by the model.

Key Words: credit risk; credit spreads; reduced-form models; stochastic volatility
History: Received: February 22, 2007;