In recent years, corporate credit risk has become an increasingly important and active area of research. This issue plays a central role in the fixed income literature, primarily because of its importance in the pricing of risky debt and credit derivatives.
Existent theoretical models to quantify the effects of credit risk on bonds prices have developed into two major branches the structural (also called the firm value) models (e.g., Merton (1974), Leland (1994), Longstaff and Schwarz (1995), and Briys and de Varenne (1997)), and the reduced-form (also called intensity) models (e.g., Jarrow and Turnbull (1995), Jarrow et al. (1997), Duffie and Singleton (1999), Bielecki and Rutkowski (2000), and Madan and Unal (2000)). Both approaches take into account credit spreads as a central component in their pricing models.
Credit spread is generally defined as the difference between yield-to-maturity on a coupon-paying corporate bond and yield-to-maturity on a coupon paying government bond of the same maturity. A great many of empirical researches, such as Delianedis and Geske (2001), and Elton et al. (2001), have been done subsequently to test the theoretical results on credit spreads.
They investigate the components of corporate credit spreads and find that default and recovery risks are not the primary components of corporate credit spreads, contrary to the traditional views as suggested by theories. They conclude that taxes, jumps, liquidity, market risk factors, and interest rate factors all play a role in explaining the credit spread.