Dynamics of credit spread moments of European corporate bond indexes

Traditional quantitative credit risk models assume that changes in credit spreads are normally distributed but empirical evidence shows that they are likely to be skewed, fat-tailed, and change behaviour over time. Not taking into account such characteristics can compromise calculation of loss proba...

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Bibliographic Details
Published in:Journal of banking & finance 2013-08, Vol.37 (8), p.3125-3144
Main Authors: Alizadeh, Amir H., Gabrielsen, Alexandros
Format: Article
Language:English
Subjects:
Bond markets
Corporate bonds
Credit spread
Credit spreads
Derivatives
Eastern Europe
GARCH
GARCH models
Indexes
Investment policy
Kurtosis
Pricing
Profitability
Regime switching
Risk management
Skewness
Spread
Stochastic models
Studies
Value at risk
VaR
Volatility
Western Europe
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Summary:Traditional quantitative credit risk models assume that changes in credit spreads are normally distributed but empirical evidence shows that they are likely to be skewed, fat-tailed, and change behaviour over time. Not taking into account such characteristics can compromise calculation of loss probabilities, pricing of credit derivatives, and profitability of trading strategies. Therefore, the aim of this study is to investigate the dynamics of higher moments of changes in credit spreads of European corporate bond indexes using extensions of GARCH type models that allow for time-varying volatility, skewness and kurtosis of changes in credit spreads as well as a regime-switching GARCH model which allows for regime shifts in the volatility of changes in credit spreads. Performance evaluation methods are used to assess which model captures the dynamics of observed distribution of the changes in credit spreads, produces superior volatility forecasts and Value-at-Risk estimates, and yields profitable trading strategies. The results presented can have significant implications for risk management, trading activities, and pricing of credit derivatives.
ISSN:0378-4266
1872-6372
DOI:10.1016/j.jbankfin.2013.02.030