The Commonality of Corporate Credit risk: A Rating-Based Approach

Description

Previous empirical studies show that corporate credit risk, including default probabilities and credit risk premium, is driven by common factors. Credit rating is the key measure of corporate credit risk in practice, given the large cross-section of corporate borrowers. Our preliminary empirical study also shows that there exists a common factor across average CDS spreads across industries. Furthermore, the dependency on the common factor is monotone across credit rating in each industry. However, this strong commonality in the corporate credit risk has not been incorporated in any credit risk model in the literature. Based on these observations, we build a parsimonious no-arbitrage reduced-form model of corporate credit risk with credit rating and industrial classification as the key cross-sectional variables. The hazard rate of default is driven by a set of common factors and an issuer-specific factor, and the common factors are driving the rating transitions and credit risk premium. To fully capture the dynamics of the common factors, we use the full spectrum of the corporate CDS spreads to estimate and test the model. The estimated model and the associated common factors enable us to study the properties of the common factors and their relations with other macroeconomic variables and how these common factors, in conjunction with credit rating and industrial classification, drive the corporate credit risk. The results of the project should shed new light on the interactions of credit rating, industrial classification, and common risk factors in shaping the corporate credit markets.