2003) “A Model of Time Varying Credit Spreads and Credit Ratings,” Working Paper

A firm’s instantaneous probability of default is allowed to depend on its credit rating as well as on market wide and firm specific factors. In addition, the probability of a change in rating is allowed to vary through time. We estimate the model using monthly data from the Lehman Brothers Fixed Income Database over the period 1986 – 1998. The results yield insights into the puzzling relationship between credit ratings and the slope of the credit spread. The pricing of defaultable bonds has always been an important topic in finance. Struc-tural models such as Merton (1974) relate the price of a bond to variability of the value of the issuing firm. More recently, attention has been focused on how ratings affect pricing. This interest has been fueled by empirical work which has shown that the dynamics of the yield spread between lower rated bonds and safer bonds is a predictor of future stock price movements.1 Despite this interest in credit spreads there is still a lack of models that can fit the dynamics and shape of credit spread curves. The correct shape for credit spread curves is something of a puzzle. Models such a