stulzcredit spread

[kasoker]

hi david

i can't seem to get the hang of stulz eqution to credit spread:

i can see the math behind that says: that the longer the maturity - the spread nerrowes, but in the real world the more the time to maturity lenghts, the more i want a compensation for the lack of uncertanty and the fact that it is riskier.

because of that i can't get also stulz Empirical Assertion:

Highly-rated debt: longer maturity > spread widens
Low-rated debt: longer maturity > spread narrows

will apprechiate your halp

ktm

 

[David Harper CFA FRM]

ktm,

Actually, you have a solid grasp on the contradiction in Stulz Chapter 18. This issue has arisen, I think, every year for the last 3 years. (two years ago i requested they remove either the analytic or the empirical assertion in Stulz b/c of the confusion). This forum contains many queries related to your observation; eg., http://forum.bionicturtle.com/viewthread/521/
http://forum.bionicturtle.com/viewthread/1807/#3652

so my recommendation is:
* Know the credit spread formula, which is nothing more than priced zero bond:
D = F*EXP[(-r + s)T] ... solved for s
... because it is the more likely to be tested

* And just take brief note of Stulz empirical observations (which indeed do contradict his model)
... but we shouldn't be troubled by the "contradiction" as the model is too simple to be reliable
... in fact, it's sort of a helpful reminder of model risk: we should not expect very simply models to be descriptive (justified by empirical observation) as, in reality, there are many fundamental (i.e., can be contracted) and technical factors (e.g., liquidity) that impact the observed relationship


David