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| A No-Arbitrage Analysis of Economic Determinants of the Credit Spread Term Structure by Liuren Wu of Baruch College, and May 18, 2005 Abstract: We present an internally consistent analysis of the economic determinants of the term structure of credit spreads across different credit-rating classes and industry sectors. Our analysis proceeds in two steps. First, we extract three economic factors from 13 time series that capture three major dimensions of the economy: inflation pressure, real output growth, and financial market volatility. Second, we build a no-arbitrage model that links the dynamics and market prices of these economic risks to the term structures of Treasury yields and credit spreads. Model estimation shows that positive inflation shocks increase Treasury yields and widen credit spreads across all maturities and credit-rating classes. Positive shocks to real output growth also increase the Treasury yields, more so at short maturities than at long maturities. The impacts on the credit spreads are positive for high credit-rating classes but become negative and increasingly so at lower credit-rating classes. The volatility factor has small positive impacts on the Treasury yield curve, but the impacts are strongly positive and persistent on the term structure of credit spreads. Finally, when we divide each rating class into two industry sectors: financial and corporate, we find that within each rating class, the credit spreads in the financial sector are wider and more volatile than are the spreads in the corporate sector. Estimation further shows that the term structure of credit spreads in the financial sector is more responsive to shocks to the economic factors. JEL Classification: E43, G12, G13. Keywords: Credit spreads, term structure, interest rates, macroeconomic factors, financial leverage, volatility, dynamic factor model, Kalman filter. Books Referenced in this Paper: (what is this?)
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