Empirical Credit Risk

Abstract

An empirical model of credit risk is based here on the observed relation between issuer credit quality, measured by yield spreads, and the attribution of issuer bond returns to interest rate changes or the issuer's equity return. High-quality bond returns are largely explained by interest rate changes, while low-quality bond returns are explained primarily by the issuers' equity returns. Intermediate-credit quality bond returns have a substantial bond market-specific component that is unexplained by either interest rate changes or equity returns. The various influences on the bond-equity return relationship allow construction of an exposure model to be used for corporate bond hedging, scenario analysis, and risk forecasting.