Measuring Credit Spread Risk

Abstract

It is widely known that the possibility of default makes the expected return distribution for financial products that are subject to credit risk highly skewed and fat-tailed. Recent development of an unbiased tail index estimator enables modeling of the additional risk presented by changes in swap spreads. Tests on data from the U.S., the U.K., Germany, and Japan indicate that we tend to grossly underestimate the risk of large spread widenings and tightenings. Estimation of swap spread risk is dramatically improved when the severity of the additional downside risk is measured and incorporated into current estimation techniques. These results are crucial in improving credit risk management and pricing out-of-the-money credit derivatives.