Default Risk and Diversification: Theory and Empirical Implications
Robert A. Jarrow
Cornell University - Samuel Curtis Johnson Graduate School of Management
Copenhagen Business School - Department of Finance
Claremont McKenna College - Robert Day School of Economics and Finance
November 30, 2003
EFA 2001 Barcelona Meetings
Recent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity's diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of ``diversifiable default risk.'' The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage-backed securities.
Number of Pages in PDF File: 34
JEL Classification: G1working papers series
Date posted: January 1, 2001
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