Ebook The Pricing of Investment Grade Credit Risk during the Financial Crisis
This paper investigates the pricing of investment grade corporate credit during the financial crisis from the perspective of a structural risk model. A crisis is typically characterized by an unexpected large drop in asset prices.
A crucial question for both investors and policymakers is to what extent the drop in asset prices reflects news about economic fundamentals and how much is attributable to increased market frictions created by disruptions in the financial system. The challenge, of course, is that both are likely to be important contributors to the price decline.
To empirically address this challenge, we utilize a structural risk model to consistently link the pricing of stocks, credit securities, and credit derivatives. We seek to understand the key drivers of the dramatic repricing of credit securities in general, and structured credit securities in particular, that has occurred over the past two years.
As an example, consider the 7&10 tranche of the major credit index of investment grade US corporations (CDX.NA.IG). From January 2007 to December 2008, the tranche saw its spread increase from 14 basis points to 8.12%. Given that this tranche was initially priced as a AAA&rated security, the enormous spread increase has led many to conclude that we are witnessing fire sales in credit markets.
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