credit spread, respect to rate of debt
- Thread starter itsyourz
- Start date
Hi suk,
I should have done a better job with the slide. I confused by repeating the confusion in Stulz (Chapter 18, page 576). IMO, the confusion is that we mix a formula with empirical findings. So, regarding the formula on slide 13 which repeats Stulz 18.6, you are absolutely correct: holding everything else constant, to increase the maturity (T) must decrease the spread. Against the formula, there is only one finding (spreads narrow with longer maturity). As the formula merely unpacks a compounding equation:
D*EXP[(rate+spread)*T] = Face
After the formula, this is where it gets utterly confusing, Stulz seems to say 2 things:
1. That if the maturity is long enough, there may be some kind of mean reversion for spreads that are extreme. Specifically, low rated debt (high spreads), if given time, may "mean revert" to lower spreads; high rated debt, that starts with low spreads, may mean revert to higher spreads.
2. Then he cites research that says, regardless, credit spreads widen with time to maturity.
I hope that explains that, at least in regard to the source for this (Stulz), there are two things: 1. the formula which has clear implications, and 2. the empirical/intuitive citations which appear to vary.
David
I should have done a better job with the slide. I confused by repeating the confusion in Stulz (Chapter 18, page 576). IMO, the confusion is that we mix a formula with empirical findings. So, regarding the formula on slide 13 which repeats Stulz 18.6, you are absolutely correct: holding everything else constant, to increase the maturity (T) must decrease the spread. Against the formula, there is only one finding (spreads narrow with longer maturity). As the formula merely unpacks a compounding equation:
D*EXP[(rate+spread)*T] = Face
After the formula, this is where it gets utterly confusing, Stulz seems to say 2 things:
1. That if the maturity is long enough, there may be some kind of mean reversion for spreads that are extreme. Specifically, low rated debt (high spreads), if given time, may "mean revert" to lower spreads; high rated debt, that starts with low spreads, may mean revert to higher spreads.
2. Then he cites research that says, regardless, credit spreads widen with time to maturity.
I hope that explains that, at least in regard to the source for this (Stulz), there are two things: 1. the formula which has clear implications, and 2. the empirical/intuitive citations which appear to vary.
David
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