Default Risk and Diversification: Theory and Empirical Implications

34 Pages Posted: 1 Jan 2001

See all articles by Robert A. Jarrow

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

David Lando

Copenhagen Business School

Fan Yu

Claremont McKenna College - Robert Day School of Economics and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: November 30, 2003

Abstract

Recent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity's diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of ``diversifiable default risk.'' The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage-backed securities.

JEL Classification: G1

Suggested Citation

Jarrow, Robert A. and Lando, David and Yu, Fan, Default Risk and Diversification: Theory and Empirical Implications (November 30, 2003). Available at SSRN: https://ssrn.com/abstract=249452 or http://dx.doi.org/10.2139/ssrn.249452

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

David Lando

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark
+45 3815 3600 (Fax)

Fan Yu (Contact Author)

Claremont McKenna College - Robert Day School of Economics and Finance ( email )

500 E. Ninth St.
Claremont, CA 91711-6420
United States
(909)607-3345 (Phone)

HOME PAGE: http://www.cmc.edu/academic/faculty/profile.asp?Fac=553

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