Dynamic Interactions Between Interest-Rate and Credit Risk: Theory and evidence on the credit default swap term structure

by Ren-Raw Chen of Fordham University,
Xiaolin Chen of Morgan Stanley, and
Liuren Wu of the City University of New York

September 2011

Abstract: This paper examines the interaction between default risk and interest-rate risk in determining the term structure of credit default swap spreads at different industry sectors and credit rating classes. The paper starts with a parsimonious three-factor interest-rate dynamic term structure and projects the credit spread at each industry sector and rating class to these interest-rate factors while also allowing the projection residual dynamics to depend on the level of the interest-rate factors. Estimation shows that credit risk exhibits intricate dynamic interactions with the interest-rate factors.

JEL Classification: E43,G12,G13,C51.

Keywords: Credit default swap, credit risk, term structure, interest-rate risk, maximum likelihood estimation.

Forthcoming in: Research in Finance.

Previously titled: Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads

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