1. Components of Corporate Credit Spreads Robert Geske Components of Corporate Credit Spreads Presented By Robert Geske Professor UCLA Universitat Karlsruhe December 2002

2. Components of Corporate Credit Spreads Robert Geske Basel/BIS Concerns: Market Risk Credit Risk (Default?) What are the similarities? What are the differences?

3. Components of Corporate Credit Spreads Robert Geske Credit Exposure is: Current & Future Market & Credit Risk Credit Spreads: Composition?

4. Components of Corporate Credit Spreads Robert Geske Credit Spreads Risk Components? Default Risk Recovery Risk Tax Risk Jump Risk Liquidity Risk Market Risk

5. Components of Corporate Credit Spreads Robert Geske Literature l Merton (1974) l Black & Cox (1976), Geske (1977) l Longstaff Schwartz (1995), Leland Toft (1996) l Colin-Dufresne, Goldstein, et al (2000) l Eom, Helwege, Huang (2002) l Huang & Huang (2002) l Duffie & Lando (2001), Jarrow & Turnbull (1995) l Delianedis & Geske (1998), KMV, Leland (2002)

6. Components of Corporate Credit Spreads Robert Geske Modeling: Firm Dynamics & Payouts

7. Components of Corporate Credit Spreads Robert Geske Valuation

8. Components of Corporate Credit Spreads Robert Geske Valuation

9. Components of Corporate Credit Spreads Robert Geske Recovery: Default Costs

10. Components of Corporate Credit Spreads Robert Geske Recovery: Default Costs

11. Components of Corporate Credit Spreads Robert Geske Default Spread

12. Components of Corporate Credit Spreads Robert Geske Taxes

13. Components of Corporate Credit Spreads Robert Geske Jumps

14. Components of Corporate Credit Spreads Robert Geske Residual Spread l CS = DS + RS

15. Components of Corporate Credit Spreads Robert Geske Table 1: Panel A: With Asian Crisis Table 1 - Credit and Default Spreads Reported in basis points are the averages of the medians, quartiles, and standard deviations for each rating category with and without the Fall 1998 Asian/LTC crisis. Firms indicates the average number of firms per month during this period. Panel A: With Asian/LTC Crisis Nov 1991 – Dec 1998 RatingDefault SpreadCredit Spread Med1Q3QStdFirmsMedStd AAA1.60.07.73.11835.513.3 AA2.90.415.08.27147.610.3 A11.42.743.019.819370.014.5 BBB26.16.681.452.3188117.125.4

16. Components of Corporate Credit Spreads Robert Geske Table 1: Panel B: Without Asian Crisis Table 1 - Credit and Default Spreads Reported in basis points are the averages of the medians, quartiles, and standard deviations for each rating category with and without the Fall 1998 Asian/LTC crisis. Firms indicates the average number of firms per month during this period. Nov 1991 – June 1998 RatingDefault SpreadCredit Spread Med1Q3QStd MedStd AAA1.10.05.72.1 33.29.8 AA1.10.18.92.3 45.77.3 A7.11.230.14.1 67.19.1 BBB14.43.250.88.6 114.523.0 Panel B: Without Asian/LTC Crisis

17. Components of Corporate Credit Spreads Robert Geske Table 2: Panel A: With Asian Crisis Table 2 - Residual Spreads Reported in basis points are the averages of the medians, quartiles, and standard deviations of the residual spreads for each investment grade rating category with and without including the Asian/LTC Crisis of the Fall of 1998. Panel A: With Asian/LTC Crisis Nov 1991 – Dec 1998 RatingMed1Q3Q Std % Med AAA33.8935.4927.79 14.18 0.95 AA44.7047.1532.56 9.51 0.94 A58.5767.2826.95 19.27 0.84 BBB91.01110.5935.75 34.79 0.78

18. Components of Corporate Credit Spreads Robert Geske Table 2: Panel B: Without Asian Crisis Table 2 - Residual Spreads Reported in basis points are the averages of the medians, quartiles, and standard deviations of the residual spreads for each investment grade rating category with and without including the Asian/LTC Crisis of the Fall of 1998. Panel B: Without Asian/LTC Crisis Nov 1991 – June 1998 RatingMed1Q3Q Std % Med AAA32.1033.2127.52 14.20 0.97 AA44.5845.5936.78 9.26 0.98 A59.9965.9037.03 17.67 0.89 BBB100.13111.2963.33 25.39 0.87

19. Components of Corporate Credit Spreads Robert Geske Table 3: Summary of Spreads For Diffusion Models Table 3 - Summary of Spreads for Diffusion Models Nov 1991 - Dec 1998 DefaultCreditResidual RatingMedStdMedStdMedStdResidual % CS AAA1.63.135.513.333.914.1895.4% AA2.98.247.610.344.79.5194.0% A11.419.870.014.558.619.2783.7% BBB26.152.3117.125.491.034.7977.7% Spreads are in basis points. Default spread is calculated with the Merton model with accrued dividends and interest payments and a 45% loss associated with default. The model is calibrated such that the equity price and volatility are matched exactly. The default spread is the average over time of the cross-sectional medians for firms in each rating class. Credit spread data is from CMS for matched duration. Residual spread is the difference.

20. Components of Corporate Credit Spreads Robert Geske Table 4: Residual, Credit and Default Spread Correlations Table 4: Panel A: Credit and Default Spread Correlation Default With Asian / LTC crisis Without Asian / LTC Crisis Credit AAAAAABBB AAAAAABBB AAA0.6320.4870.5400.199AAA0.2670.037-.042-.291 AA0.6130.6820.7250.396AA0.042-.040-.0770.335 A0.5910.6800.7560.490A-.3170.057-.1360.183 BBB0.6440.6780.7690.493BBB-.2630.1110.0960.129

21. Components of Corporate Credit Spreads Robert Geske Table 4: Residual, Credit and Default Spread Correlations Table 4: Panel B: Credit Spread Correlation Default With Asian / LTC crisis Without Asian / LTC Crisis Credit AAAAAABBB AAAAAABBB AAA1.0000.7620.7600.274AAA1.0000.5910.495-0.089 AA0.7621.0000.9050.577AA0.5911.0000.8150.429 A0.7600.9051.0000.712A0.4950.8151.0000.640 BBB0.2740.5770.7121.000BBB-0.0890.4290.6401.000

22. Components of Corporate Credit Spreads Robert Geske Table 4: Residual, Credit and Default Spread Correlations Table 4: Panel C: Default Spreads Correlation Default With Asian / LTC crisis Without Asian / LTC Crisis Credit AAAAAABBB AAAAAABBB AAA 1.0000.7270.7450.774 AAA 1.0000.6610.2820.315 AA 0.7271.0000.9700.933 AA 0.6611.0000.5230.614 A 0.7450.9701.0000.977 A 0.2820.5231.0000.870 BBB 0.7740.9330.9771.000 BBB 0.3150.6140.8701.000

23. Components of Corporate Credit Spreads Robert Geske Table 5 Effects of Fractional Recovery Rates and Taxes On Default Spreads Nov 1991 - Dec 1998 Panel A Fractional Recovery Rates (FRR) Rating100%80%60%40%20%0% AAA024578 AA1357911 A61420273339 BBB172940506172

24. Components of Corporate Credit Spreads Robert Geske Table 5 Effects of Fractional Recovery Rates and Taxes On Default Spreads Nov 1991 - Dec 1998 Panel B Variable Tax Rate with FRR = 88% Rating0%2%4%6%8%10% AAA2610141822 AA3914202631 A141824313845 BBB293339465259 Spreads are in basis points. Default spread is calculated with the Merton model with accrued dividends and interest payments and a variable recovery associated with default. The model is calibrated such that the equity price and volatility are matched exactly. The default spread is the average over time of the cross-sectional medians for firms in each rating class. Credit spread data is from CMS for matched duration. Residual spread is the difference.

25. Components of Corporate Credit Spreads Robert Geske Table 6: Jump-Diffusion Models Necessary Jump Parameters and Volatility CS>DSRatingAAAAAABBB S/V 0.8000.7500.6400.550 V Vol implied 0.1910.1700.1600.157 S Vol observed No jumps 0.2380.2260.2460.278 CS = DSFreq / YearAmplitude Additive119%20%18%22% Additive214% 13%15% V Vol implied jumps 0.3300.3370.3520.425 Assess the impact on default spreads of a jump-diffusion model instead of a pure diffusion model for the firm value. Default spreads are estimated with a jump-diffusion process for the firm value following Merton (1976, 1979). Jumps are assumed distributed lognormal with zero mean. The observed stock volatility is reported. Base case is the Merton model with no jumps and the default spread is much less than the credit spread. Next the base case parameters are used and a jump process is added (Additive). Jump magnitude is increased until the default spreads are equal to the credit spreads. The frequency of the jumps is annual. Table shows the necessary total firm volatility which is about the same for the necessary jump scenarios.

26. Components of Corporate Credit Spreads Robert Geske Table 7 Residual Spread Regression Analysis of Components RatingLog(Vol)PREM AAA 0.0030.006-0.071-0.0250.0820.1290.017 t-stat0.4870.149-1.888-0.7690.2620.488 AA-0.007-0.122-0.056-0.0510.582-0.2360.025 t-stat-0.985-1.964-1.069-1.3231.376-0.597 A-0.017-0.245-0.019-0.0801.330-0.7720.096 t-stat-1.763-2.179-0.331-1.7752.266-1.559 BBB-0.041-0.5130.064-0.0882.264-1.6700.070 t-stat-1.915-1.8210.572-0.7702.326-2.044 Regressions of changes in the residual spread on changes in a measure of trading volume, the level of risk free rate, changes in the slope of term premium, US equity market return, and volatility as changes in the squared US equity market return, and the adjusted R 2 are reported. The adjusted R 2 is much higher (45-60%) when explaining the level on the residual spread.

27. Components of Corporate Credit Spreads Robert Geske Components of Corporate Credit Spreads Thank You