Understanding the relationship between credit and interest rate risk is critical to many applications in finance, from valuation of credit and interest rate-sensitive instruments to risk management. This study empirically examines the relationship between interest rates and default risk using firm level corporate default data in the United States between 1982 and 2008. We find significant negative contemporaneous correlations between the changes in short interest rates and aggregate default rates, with a particularly strong relationship around financial crises. We also explore the explanatory power of interest rate variables in predicting default when conditioned on Moody’s KMV EDF™ credit measures | OCTOBER 2 2009 Moody s ANALYTICS THE RELATIONSHIP BETWEEN DEFAULT RISK AND INTEREST RATES AN EMPIRICAL STUDY RESEARCH INSIGHT AUTHORS Understanding the relationship between credit and interest rate risk is critical to many applications in finance from valuation of credit and interest rate-sensitive instruments to risk Andrew Kaplin management. This study empirically examines the relationship between interest rates and Amnon Levy default risk using firm level corporate default data in the United States between 1982 and 2008. Shisheng Qu We find significant negative contemporaneous correlations between the changes in short Danni Wang interest rates and aggregate default rates with a particularly strong relationship around financial crises. We also explore the explanatory power of interest rate variables in predicting Yashan Wang default when conditioned on Moody s KMV EDF credit measures. In addition we study the impact of changes in short rates expected changes in short rates interest rate slopes and Jing Zhang unexpected changes in short rates. Conditional on the EDF credit measure interest rates and default were not found to have any statistically significant correlation. Our findings have a number of important implications for risk measurement and management. Copyright 2009 Moody s Analytics Inc. All rights reserved. Credit Monitor CreditEdge CreditEdge Plus CreditMark DealAnalyzer EDFCalc Private Firm Model Portfolio Preprocessor GCorr the Moody s logo the Moody s KMV logo Moody s Financial Analyst Moody s KMV LossCalc Moody s KMV Portfolio Manager Moody s Risk Advisor Moody s KMV RiskCalc RiskAnalyst RiskFrontier Expected Default Frequency and EDF are trademarks or registered trademarks owned by MIS Quality Management Corp. and used under license by Moody s Analytics Inc. ACKNOWLEDGEMENTS We are grateful to our MKMV Research colleagues for their generous comments. All remaining errors are of course our own. Published by Moody s KMV Company To contact Moody s .
