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Office of Research Estimating Credit Risk Premia

By Lim Kian Guan, Lim Kian Guan and Jel Codes

Abstract

This paper investigates the nature of the credit risk premium adjustments in the Jarrow-Lando-Turnbull model of credit risk spreads. The adjustments relate the equivalent martingale measures to the empirical measures of unconditional transition probabilities. We provide a modified version of the risk adjustment that allows a linear partition of the credit spread into an unconditional default component, a recovery component, and the risk premium adjustment. The risk adjustments are related to conditional default risk, illiquidity risk, and other factors not related to recovery effects. The log-transform of these risk adjustments can be specified as linear regressions on a set of macroeconomic variables. Some new insights are gained pertaining to these conditional risks such as a typical upward sloping term structure and sensitivity to short-term Treasury rates and increasing forward rates. The conditional risks appear to be insensitive to market returns

Topics: Credit Spreads, Risk Adjustments, No-arbitrage equilibrium, Conditional Risks
Year: 2003
OAI identifier: oai:CiteSeerX.psu:10.1.1.416.1779
Provided by: CiteSeerX
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