An Empirical Investigation Of The Short-term
Relationship Between Interest Rate Risk And
Credit Risk
Author(s)
C. Cech
Abstract
Empirical results from several studies indicate that changes in interest rates and
changes in credit spreads are negatively related in the short run. These findings
are further investigated by examining the dependence structure between interest
rate and credit risk factor changes that are computed from sovereign and
corporate bond indices. Several copulas (Gaussian, Student t, BB1, and Frank
copula) are calibrated and their goodness-of-fit is compared. No clear pattern of
the dependence structure can be observed as it varies substantially with the
duration and – concerning the credit risk factor changes – the rating of the
obligors. The Student t copula’s fit in terms of the AIC goodness-of-fit measure
is superior to that of all other copulas. The null hypothesis of a specific copula
being the true copula can be rejected for the Student t copula in the least cases.
Additionally employing a likelihood-ratio test, the null hypothesis of a Gaussian
copula can be rejected in favour of a Student t copula. The Gaussian copula
seems to underestimate the probability of joint strong risk factor changes, while
the Student t copula seems to overestimate it.
Keywords: copula, dependence, short-term, interest rate risk, credit risk, risk
measurement.
1 Introduction
Credit spreads, the difference in yield between corporate and government bonds
of similar maturity, reflect the credit risk associated with corporate bonds. The
dependence of interest rate risk, i.e. the risk associated with changes of the
interest rate term structure, and credit risk, i.e. the risk associated with ratingmigrations
or defaults of obligors, is an interesting topic to explore in the context
Keywords
copula, dependence, short-term, interest rate risk, credit risk, riskmeasurement.
Related Book
Other papers in this volume
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