An empirical study of credit spreads in an emerging market: The case of Korea

Keehwan Park, Chang Mo Ahn, Dohyeon Kim and Saekwon Kim

Pacific-Basin Finance Journal, 2013, vol. 21, issue 1, 952-966

Abstract: Empirically we test the Merton-type model (1974) of credit risk in an emerging market such as the Korean corporate bond market. For that purpose, we assume two alternative firm value processes: diffusion process for the Merton (1974) model and jump-diffusion process for our extended model in a general equilibrium setting. Our empirical results show that the diffusion model generally underpredicts spreads — which is referred to as “the credit spread underprediction puzzle” in the literature, while our jump-diffusion model somewhat raises the predicted spreads. We assert that jump raises the spreads on two grounds. First, an extremely large (negative) change tends to increase the probability for a firm to default particularly over a short-time horizon. Second, jump requires the systematic risk premium for a positively correlated firm particularly when the market turns extremely volatile.

Keywords: Diffusion process; Jump-diffusion process; Credit risk; Spread underprediction puzzle; Risk-neutral probability distribution (search for similar items in EconPapers)
JEL-codes: F34 G12 G13 G15 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:pacfin:v:21:y:2013:i:1:p:952-966

DOI: 10.1016/j.pacfin.2012.07.005

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