US Bank Credit Spreads during the Financial Crisis

TY - JOUR

T1 - US Bank Credit Spreads during the Financial Crisis

AU - Spencer, Peter

N1 - Publisher Copyright: © 2016 Elsevier B.V.

PY - 2016/10

Y1 - 2016/10

N2 - This paper argues that first passage time models are likely to better than affine hazard rate models in modelling stressed credit markets and confirms their superior performance in explaining the behavior of Credit Default Swap rates for the major US banking groups over the period of the financial crisis. Affine models find it hard to deal with periods of exceptionally high or low default risk given their assumption of a constant rate of mean reversion in the hazard rate. In contrast, first passage time models are specified in terms of the distance to default rather than the hazard rate. The persistence of shocks varies with the distance to default, allowing the default curve to invert sharply (compress) when the distance to default is low (high). I use an empirical version of the Collin-Dufresne et al. (2003) model, which contains a smoothing parameter that allows it to control the relative effect of these shocks on the short spreads and can be interpreted as an information lag.

AB - This paper argues that first passage time models are likely to better than affine hazard rate models in modelling stressed credit markets and confirms their superior performance in explaining the behavior of Credit Default Swap rates for the major US banking groups over the period of the financial crisis. Affine models find it hard to deal with periods of exceptionally high or low default risk given their assumption of a constant rate of mean reversion in the hazard rate. In contrast, first passage time models are specified in terms of the distance to default rather than the hazard rate. The persistence of shocks varies with the distance to default, allowing the default curve to invert sharply (compress) when the distance to default is low (high). I use an empirical version of the Collin-Dufresne et al. (2003) model, which contains a smoothing parameter that allows it to control the relative effect of these shocks on the short spreads and can be interpreted as an information lag.

KW - Asset pricing

KW - Bank solvency

KW - Banking efficiency

KW - Banking regulation

UR - http://www.scopus.com/inward/record.url?scp=84978647059&partnerID=8YFLogxK

U2 - 10.1016/j.jbankfin.2016.04.015

DO - 10.1016/j.jbankfin.2016.04.015

M3 - Article

SN - 0378-4266

VL - 71

SP - 168

EP - 182

JO - Journal of Banking & Finance

JF - Journal of Banking & Finance

ER -