Can Structural Models Price Default Risk? New Evidence from Bond and Credit Derivative Markets
McGill University; Swedish Institute for Financial Research (SIFR)
Stockholm School of Economics - Department of Finance
January 27, 2005
EFA 2005 Moscow Meetings Paper
Using a set of structural models, we evaluate bond yield spreads and the price of default protection for a sample of US corporations. Theory predicts that if credit risk alone explains these two quantities, their magnitudes should be similar. Our findings concur with previous results that bond yield spreads are underestimated. However, this is not systematically the case for CDS premia, which in our dataset are much lower than bond spreads. Furthermore, our results highlight the strong relationship between bond residuals and nondefault proxies, in particular illiquidity. CDS residuals exhibit no such relations. This suggests that the bond spread underestimation by our structural models may not stem from their inability to properly account for default risk, but rather from the importance of the omitted risk factors.
Number of Pages in PDF File: 40
Keywords: Credit risk, credit derivatives, corporate bonds, structural models
JEL Classification: G12, G13working papers series
Date posted: January 27, 2005 ; Last revised: October 16, 2008
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