A Theoretical Model for the Term Structure of Corporate Credit based on Competitive Advantage

• Published date: 01 March 2017
• Author: Bala Rajaratnam,Myuran Rajaratnam,Kanshukan Rajaratnam
• Date: 01 March 2017
• DOI: http://doi.org/10.1111/eufm.12095

A Theoretical Model for the Term

Structure of Corporate Credit based

on Competitive Advantage

Bala Rajaratnam

Department of Statistics, Stanford University, USA; and Financial and Risk Modeling Institute,

Stanford University, USA

E-mail: brajaratnam01@gmail.com

Kanshukan Rajaratnam

Department of Finance, Tax & African Collaboration for Quantitative Finance and Risk Research,

University of Cape-town, Rondebosch, South Africa

E-mail: kanshukan.rajaratnam@uct.ac.za

Myuran Rajaratnam

School of Economics & Business Sciences, University of the Witwatersrand, South Africa

E-mail: myuranraj@gmail.com

Abstract

We derive the term structure of co rporate credit based on the comp etitive

advantage of a firm and the tax deductibility of its interest payments. We

consider the competitive a dvantage enjoyed by the firm as the ce ntral tenet of

our model and capture its event ual demise in a probabilisti c manner. We

compensate the bond holder for exp ected losses and then provide an add itional

spread based on the tax deducti bility of interest payments. Our simple intuitive

model appears to overcome some of the well-known sho rtcomings of structural

credit risk models.

Keywords: term structure, corporate credit, competitive advantage, value-investing,

credit spread puzzle

JEL classification: G12

Bala Rajaratnam was supported in part by the National Science Foundation under Grant

DMS-1106642. Bala Rajaratnam also gratefully acknowledges Stanford Management

Company (SMC) for useful discussions and funding support. The authors are grateful to the

anonymous referee and the managing Editor for their deep insights as well as their

thoughtful and valuable comments. Correspondence: Myuran Rajaratnam.

European Financial Management, Vol. 23, No. 2, 2017, 183–210

doi: 10.1111/eufm.12095

© 2016 John Wiley & Sons, Ltd.

1. Introduction

In the literature, corporat e credit is generally analyse d using one of two types of

models: structural-for m models or reduced-form mo dels. Structural models hav e the

advantage that they explicitly mo del a firm’s assets, generally assu ming that the firm’s

assets follow a geometric Brownian motion or so me modification thereof. Re duced-

form models, as the name implies , are much simpler in that they need not formally link

afirm’s assets to the corporate cred it issued by it. Instead, th ey rely on exogenously

specified parameters (such as h azard rates and recovery rates ) to value corporate

credit.

1

In this paper, we present a novel alternative approach to an alysing corporate

credit. Our approach has som e similarities to both stru ctural form models and redu ced

form models but also has some fund amental differences that di stinguish it from these

two classes. Although our mode l parameters have some parall els to reduced form

models, the key difference is that we start off with a model fo r an unlevered firm and

only thereafter we conside r the various claims on the firm. Fu rthermore, our model

parameters are endogenous ly and explicitly linked to t he economics of firm

profitability. The key difference between our model and structu ral models is that

we place less significance on the volatility of the firm’s assets; instead, we concentrate

on an important factor that her eto has been largely ignored in the literature: the

competitive advantage enjoyedbythefirm.

Robert Merton’s seminal work (Merton, 1974) stands out as a towering achievement

in the field of Corporate Debt Valuation. Merton’s work assumes that a firm’s value

follows a diffusion process with constant volatility (as described by the Geometric

Brownian Motion). On the one hand, share prices, firm values and debt values clearly

exhibit volatility and therefore it is not unexpected that volatility plays an integral part in

modern financial literature. However, on the other hand, asset volatility, which is

employed in structural models, is not directly observable and has to be estimated from

other metrics such as equity volatility.

2

The field of behavioural finance also suggests

that a market derived parameter like equity volatility can be an impure signal given that it

can be contaminated by the emotional perception (‘fear and greed’) of the market

participants (see Shleifer, 2000; Tversky and Kahneman, 1974; Thaler, 1993; and

Akerlof and Shiller, 2009 and references therein for further details on behavioural

finance). Furthermore, as pointed out by Eom et al. (2004), standard structural models

have difficulty in accurately predicting credit spreads and the major challenge facing

them is to raise model spreads, without resorting to overly aggressive assumptions on

parameters like volatility and leverage, to try and match observed spreads. It is therefore

not unreasonable, in our view, to consider an alternative to asset volatility as a measure of

risk in credit risk models.

Our exposition on Corporate Credit Valuation (presented here) takes a different

approach. In the place of volatility, we employ another oft-forgotten but perhaps equally

1

A survey on both these classes of credit risk models can be found in, for example, Altman

et al. (2004), Dai and Singleton (2003) and Sundaresan (2000).

2

To be fair, our competitive advantage parameter, p, is also not directly observable and has to

be inferred from other metrics. However, as we show in the results section, for investment

grade debt, our results are reasonably robust to a sensitivity test on the competitive advantage

parameter, p.

© 2016 John Wiley & Sons, Ltd.

184 Bala Rajaratnam, Kanshukan Rajaratnam and Myuran Rajaratnam