This paper investigates the nature of the credit risk premium adjustments in the Jarrow-Lando-Turnbull model of credit risk spreads. The adjustments relate the equivalent martingale measures to the empirical measures of unconditional transition probabilities. The author provides a modified version of the risk adjustment that allows a linear partition of the credit spread into an unconditional default component, a recovery component, and the risk premium adjustment. The risk adjustments are related to conditional default risk, illiquidity risk, and other factors not related to recovery effects. The log-transform of these risk adjustments can be specified as linear regressions on a set of macroeconomic variables. Some new insights are gained pertaining to these conditional risks such as a typical upward sloping term structure and sensitivity to short-term treasury rates and increasing forward rates. The conditional risks appear to be insensitive to market returns.

Credit spread is the additional yield required by the market in holding credit-risk corporate bond relative to treasury bond of the same maturity. The spread is typically computed as the difference between the spot rates of the corporate and the treasury discount bonds. Understanding the economic factors that influence credit spread dynamics is an important issue in finance as the spreads determine relative corporate bond prices.

Duffee (1998) indicates that 3-month treasury rate and also treasury slope (30-year treasury bond rate less 3-month bill rate) have negative impact on credit spread changes. Izvorski (1997) shows the importance of recovery ratios and survival times in determining corporate bond prices. Similar variables are used by Fons (1994) to explain credit spread term structures. Janosi, Jarrow and Yildrim (2002) show components of expected losses and liquidity discounts in debt prices and credit spreads. Bevan and Garzarelli (2000) relate credit spread movements to business cycle variables. Collin- Dufresne, Goldstein and Martin (2001) find credit-related economic variables such as leverage, liquidity proxies, and volatility, which help to explain a part of credit spread movement. They also show S&P 500 market returns to be negatively correlated with credit spreads. Elton, Gruber, Agrawal and Mann (2001) suggest that unexplained spread movements are related to systematic risks in the economy. This idea is also contained in Pedrosa and Roll (1998). Wu and Yu (1996) consider preference factor such as risk aversion to impact on debt yield dynamics. Yu (2002) shows empirically that firms with higher accounting disclosures tend to have lower credit spreads. Duffie and Lando (2001) provide the theory for the impact of accounting information on credit spreads.

Estimating Credit Risk Premia, default risk, illiquidity risk, log-transform, market returns, risk spreads, martingale measures, empirical measures, modified version, linear partition, risk adjustments, premium adjustment, recovery effects, linear regressions, macroeconomic variables, conditional risks, typical upward,term structure,short-term treasury, forward rates.