Rating, Credit Spread, and Pricing Risky Debt: Empirical Study on Taiwan's Security Market

Ken Hung, Chang-Wen Duan and Chin Yang
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Ken Hung: Department of Finance, National Dong Hwa University
Chang-Wen Duan: Department of Finance, Tamkang University
Chin Yang: Department of Economics, Clarion University

Annals of Economics and Finance, 2006, vol. 7, issue 2, 405-424

Abstract: This paper focuses on evaluating the credit risk of corporate bond in the fixed income market of Taiwan. We apply Vasicek (1977) model into Merton's (1974) option framework and obtain a closed-form solution of the options model. The solution algorithm employs the Newton-Raphson method in combination with the inverse quadratic interpolation and bisection technique of Dekker (1967) to find out the roots and calculate the credit spread. The result shows that the average credit spread is 1.346%, and the credit spread of TSE (Taiwan Stock Exchange) listed firm is higher than that of OTC firms, while the one with bank guarantee is higher than the one without. We find negative correlation between VaR rating, TEJ (Taiwan Economic Journal) rating and credit spread, implying that the higher the market risk is, the lower the required premium is by the bondholders, and credit spread is expected to be lower. Testing the hypothesis of Duffee (1998), we find a negative correlation between the Taiwan Stock weighted index and credit spread. It implies that the term structure of interest rate is an upward type. As firm's equity value rises, the index return follows suit. While the bond default probability decreases, and the credit spread is expected to decrease.

Keywords: Credit spread; Default risk; Interest rate risk; Market price of risk; Put-call parity; VaR (Value at Risk) (search for similar items in EconPapers)
JEL-codes: C61 C63 G12 G13 (search for similar items in EconPapers)
Date: 2006
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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