Category Archives: income

Investors require a premium for taking on credit risk. Not only does this premium, in other words the credit spread, have to increase with decreasing credit quality, but one also expects a higher sensitivity of spreads to changes of the fundamental environment for lower rated credits. As pointed out earlier, the assets of a company with a higher degree of leverage are nearer to the default threshold than those of a firm with a conservative balance sheet structure. In terms of the structural model the short put option on the assets of the issuer moves nearer at-the-money with decreasing credit quality, causing the delta to rise. Hence, a falling value of the assets, for example, in periods of a deteriorating economic environment and consequently declining equity markets, leads to a larger change in the credit spread the lower the credit quality of the issuer is.