This paper examines the interaction between default risk and interest-rate risk in determining the term structure of credit default swap spreads at different industry sectors and credit-rating classes. The paper starts with a parsimonious three-factor interest-rate dynamic term structure and projects the credit spread at each industry sector and rating class to these interest-rate factors while also allowing the projection residual dynamics to depend on the level of the interest-rate factors. Estimation shows that credit risk exhibits intricate dynamic interactions with the interest-rate factors.

With the recent significant growth in the single-name credit default swap (CDS) market has come the need for accurate and computationally efficient models to value these instruments. While the model developed by Duffie, Pan, and Singleton (2000) can be used, the solution is numerical (solving a series of ordinary differential equations) rather than explicit. In this paper, we provide an explicit solution to the valuation of a credit default swap when the interest rate and the hazard rate are correlated by using the “change of measure” approach and solving a bivariate Riccati equation. CDS transaction data for the period 2/15/2000 through 4/8/2003 for 60 firms are used to test both the goodness of fit of the model and provide estimates of the influence of economic variables in the market for credit-risky bonds.