Macroeconomic conditions, firm characteristics, and credit spreads

Abstract

We study a structural model that allows us to examine how credit spreads are affected by the interaction betweeen macroeconomic conditions and firm characteristics. Unlike most other structural models, our model explicitly incorporates equilibrium macroeconomic dynamics and models a firm's cash flow as primitive processes. Corporate securities are priced as contingent claims written on cash flows. Default occurs when the firm's cash flow cannot cover the interest payments and the recovery rate is dependent on the economic condition at default. Our model produces the folloBarLinewing predictions: (i) credit spread is mostly negatively correlated with interest rate; (ii) credit spread yield curves are upward sloping for low-grade bonds: (iii) firm characteristics have significant effects on credit spreads and these effects also vary with economic conditions. These predictions are consistent with the available empirical evidence and generate implications for further empirical investigation. © Springer Science + Business Media, LLC 2006.