Credit Spreads, Leverage and Volatility: A Cointegration Approach

This work documents the existence of a cointegration relationship between credit spreads, leverage and volatility for a large set of US companies. It is shown that accounting for the long-run equilibrium dynamic between these variables is essential to correctly explain credit spread changes. Using a novel structural model in which equity is modelled as a compound option on the firm’s assets, a new methodology for estimating the unobservable market asset value and volatility is developed. The proposed model allows to reduce pricing errors in predicting credit spreads. In terms of correlation analysis, it is shown that not accounting for the long-run equilibrium equation embedded in an Error Correction Mechanism (ECM) results into a misspecification problem when regressing a set of explanatory variables onto the spread changes. Once credit spreads, leverage and volatility are correctly modelled, the fit of the regressions sensibly increases if compared to the results of previous research.