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An empirical study of credit spreads in an emerging market: The case of Korea

Author

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  • Park, Keehwan
  • Ahn, Chang Mo
  • Kim, Dohyeon
  • Kim, Saekwon

Abstract

Empirically we test the Merton-type model (1974) of credit risk in an emerging market such as the Korean corporate bond market. For that purpose, we assume two alternative firm value processes: diffusion process for the Merton (1974) model and jump-diffusion process for our extended model in a general equilibrium setting. Our empirical results show that the diffusion model generally underpredicts spreads — which is referred to as “the credit spread underprediction puzzle” in the literature, while our jump-diffusion model somewhat raises the predicted spreads. We assert that jump raises the spreads on two grounds. First, an extremely large (negative) change tends to increase the probability for a firm to default particularly over a short-time horizon. Second, jump requires the systematic risk premium for a positively correlated firm particularly when the market turns extremely volatile.

Suggested Citation

  • Park, Keehwan & Ahn, Chang Mo & Kim, Dohyeon & Kim, Saekwon, 2013. "An empirical study of credit spreads in an emerging market: The case of Korea," Pacific-Basin Finance Journal, Elsevier, vol. 21(1), pages 952-966.
    • Handle: RePEc:eee:pacfin:v:21:y:2013:i:1:p:952-966
    DOI: 10.1016/j.pacfin.2012.07.005
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    2. Heshmati, Almas, 2013. "The Effect of Credit Guarantees on R&D Investment of SMEs in Korea," IZA Discussion Papers 7851, Institute of Labor Economics (IZA).

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    More about this item

    Keywords

    Diffusion process; Jump-diffusion process; Credit risk; Spread underprediction puzzle; Risk-neutral probability distribution;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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