For a capital market simulation of the explicit corporate yield curve type, the parameters of this topic define the “spreads” over government (spot) yields used to calculate short term (1 year) and long term (30 year) corporate bond yields, essentially by adding these “spreads” to the annual real rates of return generated for government bonds according to the parameters of the Real Rate & Term Premium topic. Thus government yields are generated first, then the spreads are calculated and corporate spot yields are set equal to the government spot yields plus the appropriate spread. Thirty year corporate bond yields are calculated from the corporate spot yields, assuming semi-annual coupon payments.

In practice, the long term corporate spread is calculated first, for each year of the simulation period, and its value is then used to calculate the short term corporate spread. In these calculations, the credit spread is assumed to be lognormally distributed (constrained to ten standard deviations above the mean).

The Short term spread, or short term credit spread, is the excess of the 1 year corporate spot rate (or return rate) over the 1 year government spot rate (or return rate). The parameters of this section are as follows:

• Mean specifies the average expected value of the short term credit spread over the (entire) time period of the simulation.

• Standard deviation indicates the desired dispersion about the mean of the simulated trials of the short term credit spread.

• Correlation with short government yield indicates the relationship between the expected short term credit spread and the short term government yields. For example, if the value is negative, then as government yields increase credit spreads will tend to decrease. The correlation value entered must be between -1 and 1, where a value close to 0 indicates little relationship, and a value close to 1 indicates a very tight relationship, between the 1 year credit spread and the 1 year government spot rate.

• Correlation with unexpected inflation indicates the relationship between the expected short term credit spread and unexpected inflation. For example, if the value is negative, credit spreads will tend to decrease as inflation rises. The correlation value entered must be between -1 and 1, where a value of 0 indicates no relationship between unexpected inflation and short term credit spreads.

• Serial correlation indicates, for the second and later years of the capital market simulation, the relationship of the expected current year short term credit spread to the prior year short term credit spread. This value is expected to be between 0 and 1, where 0 indicates no relationship. Note that this parameter is not applicable to the calculation of simulated credit spreads for the first year of the capital market simulation.

• Previous year value is the short term credit spread for the year prior to the first year of the capital market simulation. This value impacts the initial corporate spot and yield curves shown under the Yield Curve button (for the first year of the simulation) and, through those curves, the beginning of the first year’s simulated corporate bond 30 year yield. The Serial correlation value entered does not apply to this (first year) calculation.

The Long term spread, or long term credit spread, is the excess of the 30 year corporate spot rate over the 30 year government spot rate. The parameters of this section are as follows:

• Mean is the average expected excess of a 30 year corporate spot rate over a 30 year government spot rate over the (entire) time period of the simulation.

• Standard deviation indicates the desired dispersion about the mean of the simulated trials of the long term credit spread.

• Correlation with long government yield indicates the relationship between the expected long term credit spread and the long term government spot rates. For example, if the value is negative, then as government yields increase, credit spreads will tend to decrease. The correlation value entered must be between -1 and 1, where a value close to 0 indicates little relationship, and a value close to 1 indicates a very tight relationship, between the 30 year credit spread and the 30 year government spot rate.

• Correlation with unexpected inflation indicates the relationship between the expected long term credit spread and unexpected inflation. For example, if the value is negative, credit spreads will tend to decrease as inflation rises. The correlation value entered must be between -1 and 1, where a value of 0 indicates no relationship between unexpected inflation and long term credit spreads.

• Serial correlation indicates, for the second and later years of the capital market simulation, the relationship of the expected current year long term credit spread to the prior year long term credit spread. This value is expected to be between 0 and 1, where 0 indicates no relationship. Note that this parameter is not applicable to the calculation of simulated credit spreads for the first year of the capital market simulation.

• Previous year value is the long term credit spread for the year prior to the first year of the capital market simulation. This value impacts the initial corporate spot and yield curves shown under the Yield Curve button (for the first year of the simulation) and, through those curves, the beginning of the first year’s simulated corporate bond 30 year yield. The Serial correlation value entered does not apply to this (first year) calculation.

The final parameter is the Short spread correlation with long spread, which indicates the relationship between the expected short term, or 1 year, credit spread and the expected long term, or 30 year, credit spread. This value is expected to be between 0 and 1, where 0 indicates no relationship.