A Comparison of Bond Pricing Models in the Pricing of Credit Risk

Abstract:     
This paper compares alternative default-free bond pricing models in their abilities to price the credit risk of companies. The theoretical framework is the reduced-form approach of Duffie and Singleton (1999). The parameters of a CKLS (1992) type stochastic differential equation that describes the dynamics of the credit spreads on coupon bonds are estimated by using the GMM. The data are credit spreads of 112 coupon bonds from 26 companies over the period 1986-1994. The estimation takes into account biases toward mean reversion induced by the unit-root problem and survivorship. The findings support most strongly the Brennan and Schwartz (1980) model that implies credit spreads which are mean-reverting and lognormally distributed.

JEL Classifications: C23, C24, G12, G13

Working Paper Series