Are Credit Spreads Too Low or Too High? - A Hybrid Barrier Option Approach

Based on the works of Brockman and Turtle (2003) and Giesecke (2004), we proposed in this study a hybrid barrier option model with corporate capital gains tax which is free of problems within the structural model in explaining observed credit spreads. Our approach does not predict credit spreads that are too low for investment grade corporate bonds; neither does it predict credit spreads that are too high for high yield issues. Our empirical analysis supports the validity of this model over the structural model. When credit spreads are quoted abnormally higher than expected, they tend to persist. Otherwise the reversion to long term equilibrium is significant and prompt. This asymmetric pricing behavior is validated with a method introduced by Enders and Granger (1998) and Enders and Siklos (2001). The pricing asymmetry could not have been produced by a structural model employing only standard option. But it is consistent with a hybrid barrier option model. Our model characterizes the valuation of debt under financial stress and the asymmetric price pattern better than both the classical structural and the standard barrier option approaches. This study provides helpful implications especially for the medium and high yield issues in pricing as well as portfolio diversification.