Parsimonious Estimation of Credit Spreads

Abstract

The traditional method of credit spread estimation based on subtracting independently estimated risk-free and risky term structures of interest rates can yield unrealistically shaped and often irregular credit spread curves. A more parsimonious joint estimation of the risk-free term structure and the credit spread might serve be a good alternative, but it is hard to decide whether a seemingly irregular shape of the credit spread curve is an economic result or is merely an artifact of the estimation model. An empirical examination of European Monetary Union government bond data shows that traditional estimation models with different functional forms produce differing irregularities in the credit spread curves, while joint estimation procedures result in well-behaved and consistent curves that are less volatile. The more parsimonious joint estimation procedures have virtually the same explanatory power as the traditional methods. A simple linear joint cubic splines specification performs surprisingly well compared to a more comprehensive non-linear model.