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US Bank Credit Spreads during the Financial Crisis

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JournalJournal of Banking & Finance
DateAccepted/In press - 21 Apr 2016
DateE-pub ahead of print - 25 Jun 2016
DatePublished (current) - Oct 2016
Volume71
Pages (from-to)168-182
Early online date25/06/16
Original languageEnglish

Abstract

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.

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© 2016 Elsevier B.V. This is an author-produced version of the published paper. Uploaded in accordance with the publisher’s self-archiving policy. Embargo period: 18 months

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