Specification Analysis of Structural Credit Risk Models

44 Pages Posted: 13 Mar 2008 Last revised: 22 Jul 2009

See all articles by Jing-Zhi Huang

Jing-Zhi Huang

Pennsylvania State University - University Park - Department of Finance

Hao Zhou

SUSTech Business School; Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: October 2008

Abstract

In this paper we conduct a specification analysis of structural credit risk models, using term structure of credit default swap (CDS) spreads and equity volatility from high-frequency return data. Our study provides consistent econometric estimation of the pricing model parameters and specification tests based on the joint behavior of time-series asset dynamics and cross-sectional pricing errors. Our empirical tests reject strongly the standard Merton (1974) model, the Black and Cox (1976) barrier model, and the Longstaff and Schwartz (1995) model with stochastic interest rates. The double exponential jump-diffusion barrier model (Huang and Huang, 2003) improves significantly over the three models. The best one among the five models considered is the stationary leverage model of Collin-Dufresne and Goldstein (2001), which we cannot reject in more than half of our sample firms. However, our empirical results document the inability of the existing structural models to capture the dynamic behavior of CDS spreads and equity volatility, especially for investment grade names. This points to a potential role of time-varying asset volatility, a feature that is missing in the standard structural models.

Keywords: Structural Credit Risk Models, Credit Default Swap Spreads, High Frequency Equity Volatility, Consistent Specification Analysis, Pricing Error Diagnostics

JEL Classification: G12, G13, C51, C52

Suggested Citation

Huang, Jing-Zhi Jay and Zhou, Hao, Specification Analysis of Structural Credit Risk Models (October 2008). AFA 2009 San Francisco Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1105640 or http://dx.doi.org/10.2139/ssrn.1105640

Jing-Zhi Jay Huang (Contact Author)

Pennsylvania State University - University Park - Department of Finance ( email )

University Park, PA 16802
United States

HOME PAGE: http://www.personal.psu.edu/jxh56

Hao Zhou

SUSTech Business School ( email )

1088 Xueyuan Avenue, Nanshan District
Southern University of Science and Technology
Shenzhen, Guangdong
China
+86-0755-88010464 (Phone)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing, 100083
China
+86-10-62790655 (Phone)

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