1
$\begingroup$

Assume a bond portfolio in an ALM [Asset Liability Management] model or an ESG [Economic Scenario Generation] portfolio model. In order to be market consistent, a spread over the risk-free curve is calculated for each bond at $t=0$ to match the market value.

Without any further information about e.g. changes in liquidity or credit risk, I would have assumed that the spread stays constant over the lifetime of the bond in the model. However, I have seen that at least one ESG allows to phase out the spread over time in a linear way.

What is the current market practice concerning these spreads and do some academic papers about dynamic modelling of these spreads exist?

$\endgroup$
1
$\begingroup$

It is common to observe a term structure of spread when there are bonds with different maturities for the same issuer, or when CDS with different maturities are available for that issuer.

For issuers with poor rating the term structure might be decreasing, meaning that conditional upon short term survival the issuer is expected to get better.

An ESG that evolves trajectories around forward curves to try to preserve some kind of risk neutrality would therefore see the spread of a given bond for such an issuer diminish over time. Without using a full term structure making the spread evolve linearly between an initial value and a final value would make sense.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.