Estimating Credit Spreads

June 19, 2013

Credit spreads refer to the difference in interest rates charged by borrowers to cover the default-related risks involved with any loan or set of cash flows. The concept is also relevant in the context of interest rate risk reporting because -- per U.S. FAS -- it is best to include a credit adjustment term when valuing/pricing any given set of cash flows. FAS guidelines allow this adjustment to be made either to the cash flows themselves, or to the discount rates used to calculate the present value of the cash flows. The latter is probably an easier approach and in this paper, we focus on the problem of adjusting discount rates for default risk.

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