Default Dependence: The Equity Default Relationship

40 Pages Posted: 31 Jan 2008

See all articles by Stuart M. Turnbull

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business

Jun Yang

Bank of Canada

Date Written: January 10, 2008

Abstract

The paper examines three equity-based structural models to study the nonlinear relationship between equity and credit default swap (CDS) prices. These models differ in the specification of the default barrier. With cross-firm CDS premia and equity information, we are able to estimate and compare the three models. We find that the stochastic barrier model performs better than the constant and uncertain barrier models in terms of both in-sample fit and out-of-sample forecasting of CDS premia. In addition, we demonstrate a linkage between the default barrier, jump intensity, and barrier volatility estimated from our models and firm-specific variables related to default risk, such as credit ratings, equity volatility, and leverage ratios.

Keywords: credit default swaps, default risk, structural models, jump

JEL Classification: G12, G13

Suggested Citation

Turnbull, Stuart M. and Yang, Jun, Default Dependence: The Equity Default Relationship (January 10, 2008). EFA 2008 Athens Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1087992 or http://dx.doi.org/10.2139/ssrn.1087992

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Jun Yang (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

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