Explain what a change in a credit spread indicates
The idea
A credit spread compensates for expected loss and for liquidity, so a change can come from the probability of default, the loss given default, a liquidity premium or all three. A spread that widens while default probability estimates are unchanged may reflect lower expected recovery, for example because new secured debt ranks ahead, or thinner trading. Higher recovery or a secured structure narrows spreads. A useful approximation is spread ≈ annual probability of default (the hazard rate) × loss given default, before liquidity and risk premia. Spreads also move with the economic cycle and with market-wide risk appetite. Separating these causes matters, because a spread move driven by liquidity may reverse even if the issuer's credit quality is unchanged.
In the app: 3 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Credit Analysis Models
- Explain expected exposure, probability of default, loss given default and the adjustment to value for credit (CVA)
- Explain credit ratings and credit scores
- Work out a bond's expected return when its credit rating may migrate
- Explain the structural and the reduced-form approaches to modelling corporate credit risk, covering what each assumes and its strong and weak points
- Work out a bond's value and credit spread from assumed credit risk parameters
- Explain what drives the credit spread term structure, and read what a given credit spread curve across maturities shows
- Contrast analysing corporate debt for credit risk with the analysis that securitized debt requires