A Reduced Form Model of Default Spreads with Markov-Switching Macroeconomic Factors

53 Pages Posted: 9 Nov 2010

See all articles by Georges Dionne

Georges Dionne

HEC Montreal - Department of Finance

Geneviève Gauthier

HEC Montreal - Department of Decision Sciences; HEC Montreal - Department of Management Sciences

Khemais Hammami

HEC Montreal - Department of Finance

Mathieu Maurice

HEC Montréal

Jean-Guy Simonato

HEC Montréal

Date Written: November 8, 2010

Abstract

An important research area of the corporate yield spread literature seeks to measure the proportion of the spread that can be explained by factors such as the possibility of default, liquidity, tax differentials and market risk. We contribute to this literature by assessing the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion of yield spreads caused by the risk of default in the context of a reduced form model. For this purpose, we extend the Markov Switching risk-free term structure model of Bansal and Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond yields as well as credit default swap premia. The model is calibrated with consumption, inflation, risk-free yields and default data for Aa, A and Baa bonds from the 1987-2008 period. We find that our macroeconomic factors are linked with two out of three sharp increases in the spreads during this sample period, indicating that the variations can be related to macroeconomic undiversifiable risk. The estimated default spreads can explain almost half of the 10 years to maturity industrial Baa zero-coupon yields in some regime. Much smaller proportions are found for Aa and A bonds with numbers around 10%. The proportions of default estimated with credit default swaps are higher, in many cases doubling those found with corporate yield spreads.

Keywords: Credit Spread, Default Spread, Markov Switching, Macroeconomic Factors, Reduced Form Model of Default, Random Subjective Discount Factor, Credit Default Swap, CDS

JEL Classification: G12, G13.

Suggested Citation

Dionne, Georges and Gauthier, Genevieve and Hammami, Khemais and Maurice, Mathieu and Simonato, Jean-Guy, A Reduced Form Model of Default Spreads with Markov-Switching Macroeconomic Factors (November 8, 2010). Available at SSRN: https://ssrn.com/abstract=1705479 or http://dx.doi.org/10.2139/ssrn.1705479

Georges Dionne (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada
514-340-6596 (Phone)
514-340-5019 (Fax)

HOME PAGE: http://www.hec.ca/gestiondesrisques/

Genevieve Gauthier

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada

Khemais Hammami

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

Mathieu Maurice

HEC Montréal ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

Jean-Guy Simonato

HEC Montréal ( email )

3000, chemin de la Cote-Sainte-Catherine
Service de l'enseignement de la finance
Montreal, Quebec H3T 2A7
Canada
514-340-6807 (Phone)
514-340-5632 (Fax)

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