This paper investigates a two-factor affine model for the credit spreads on corporate bonds. The Þrst factor can be interpreted as the level of the spread, and the second factor is the volatility of the spread. The riskless interest rate is modeled using a standard two-factor affine model, thus leading to a four-factor model for corporate yields. This approach allows us to model the volatility of corporate credit spreads as stochastic, and also allows us to capture higher moments of credit spreads. We use an extended Kalman Þlter approach to estimate our model on corporate bond prices for 108 Þrms. The model is found to be successful at Þtting actual corporate bond credit spreads, resulting in a signiÞcantly lower root mean square error (RMSE) than a standard alternative model in both in-sample and out-of-sample analyses. In addition,key properties of actual credit spreads are better captured by the model.

This paper develops a reduced form model of interest rate swap spreads. The model accommodates both the default risk inherent in swap contracts and the liquidity difference between the swap and Treasury markets. We use an extended Kalman Þlter approach to estimate the model parameters. The model Þts the swap rates well. We then solve for the implied general collateral repo rates and use them to decompose the swap spreads into their default risk and liquidity components. This exercise shows that the default risk and liquidity components of swap spreads behave very differently: although default risk accounts for the largest share of the levels of swap spreads, the liquidity component is much more volatile. In addition, while the default risk component has been historically positive, the liquidity component was negative for much of the 1990s and has become positive since the Þnancial market turmoils in 1998.