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| A No-Arbitrage Analysis of Economic Determinants of the Credit Spread Term Structure by Liuren Wu of Baruch College, and June 2008 Abstract: From a large array of economic and financial data series, this paper identifies three fundamental risk dimensions underlying an economy: inflation, real output growth, and financial market volatility. Furthermore, through a no-arbitrage model, the paper links the dynamics and market pricing of the three risk dimensions to the term structure of U.S. Treasury yields and corporate bond credit spreads. Model estimation shows that positive inflation shocks increase Treasury yields and widen credit spreads on corporate bonds across all maturities and credit-rating classes. Positive real output growth shocks also increase Treasury yields, but they suppress the credit spreads at low credit-rating classes, thus generating negative correlations between interest rates and credit spreads. The financial market volatility factor has a small and transient effect on the Treasury yield curve, but it exerts a strongly positive and persistent effect on the credit spread term structure. The paper provides a robust and internally consistent method for extracting systematic economic information from a large array of noisy observations and establishing how different risk dimensions of the fundamental economy interact with interest rate and credit risk. JEL Classification: E43, G12, G13. Keywords: Credit spreads, term structure, interest rates, macroeconomic factors, financial leverage, volatility, dynamic factor model, Kalman filter. Published in: Management Science, Vol. 54 , No. 6, (June 2008), pp. 1160-1175. Download paper (205K PDF) 16 pages
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