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Modeling Credit Spreads and Ratings Migration

By Heber Farnsworth and Tao Li


This paper develops a theory of bond pricing in which a firm’s instantaneous probability of default is allowed to depend on its credit rating as well as on a latent systematic factor. We examine two versions of the model, one with fixed probabilities of ratings changes and another in which the probability of rating changes varies with the systematic factor. We estimate the model in a Bayesian context using monthly data from the Lehman Brothers Fixed Income Database over the period 1985 – 1998 and find strong evidence in favor of time-varying transition probabilitiesThe pricing of defaultable bonds has always been an important topic in finance. Structural models such as Merton (1974) relate the price of a bond to variability of the value of the issuing firm. More recently, attention has been focused on how ratings affect pricing. This interest has been fueled by empirical work which has shown that the dynamics of the yield spread between lower rated bonds and safer bonds is a predictor of future stock price movements. 1 Despite this interest in credit spreads there is still a lack of models that can fit both the dynamics and shape of credit spread curves

Year: 2004
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