Investigating the Sources of Default Risk: Lessons from Empirically Evaluating Credit Risk Models

53 Pages Posted: 8 Mar 2001

See all articles by Gurdip Bakshi

Gurdip Bakshi

Fox School of Business

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Frank Xiaoling Zhang

Morgan Stanley

Date Written: February 28, 2001

Abstract

From a credit risk perspective, little is known about the distress factors - economy-wide or firm-specific - that are important in explaining variations in defaultable coupon yields. This paper proposes and empirically tests a family of credit risk models. Empirically, we find that firm-specific distress factors play a role (beyond treasuries) in explaining defaultable coupon bond yields. Credit risk models that take into consideration leverage and book-to-market are found to reduce out-of-sample yield fitting errors (for the majority of firms). Moreover, the empirical evidence suggests that interest rate risk may be of first-order prominence for pricing and hedging. Measured by both out-of-sample pricing and hedging errors, the credit risk models perform relatively better for high grade bonds. Controlling for credit rating, the model performance is generally superior for longer maturity bonds compared to its shorter maturity counterparts. Using equity as an instrument reduces hedging errors. This paper provides an empirical investigation of credit risk models using observable economic factors.

Suggested Citation

Bakshi, Gurdip S. and Madan, Dilip B. and Zhang, Frank Xiaoling, Investigating the Sources of Default Risk: Lessons from Empirically Evaluating Credit Risk Models (February 28, 2001). AFA 2001 New Orleans Meetings. Available at SSRN: https://ssrn.com/abstract=262673 or http://dx.doi.org/10.2139/ssrn.262673

Gurdip S. Bakshi (Contact Author)

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

Frank Xiaoling Zhang

Morgan Stanley ( email )

1585 Broadway
New York, NY 10036
United States

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