Calibration of Structural Credit Risk Models: Implied Sensitivities and Liquidity Discounts

Abstract

Empirical tests of structural credit risk models typically ignore bond prices when estimating parameters. In this paper we depart from this, examining a calibration of the Collin-Dufresne & Goldstein (2001) model to bond prices. Using alternative specifications of a liquidity discount we evaluate the model based on fit to yield spreads and sensitivities to underlying fundamentals, producing a novel approach to evaluating the fit of a credit risk model. When augmenting with a liquidity discount we obtain a very good fit and outperform a two-factor reduced form model. Generally we understate the sensitivity towards changes in the leverage ratio and to a larger degree changes in the short interest rate. For investment grade bonds the model attributes 40% of the yield spread at 5 years of maturity to credit risk, in some agreement with the literature.

Keywords: Credit risk, structural models, liquidity discounts

JEL Classification: C52, G12, G13, G33