Can Structural Models Price Default Risk? New Evidence from Bond and Credit Derivative Markets

40 Pages Posted: 27 Jan 2005 Last revised: 16 Oct 2008

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Joel Reneby

Stockholm School of Economics - Department of Finance

Hao Wang

Tsinghua University

Date Written: January 27, 2005

Abstract

Using a set of structural models, we evaluate bond yield spreads and the price of default protection for a sample of US corporations. Theory predicts that if credit risk alone explains these two quantities, their magnitudes should be similar. Our findings concur with previous results that bond yield spreads are underestimated. However, this is not systematically the case for CDS premia, which in our dataset are much lower than bond spreads. Furthermore, our results highlight the strong relationship between bond residuals and nondefault proxies, in particular illiquidity. CDS residuals exhibit no such relations. This suggests that the bond spread underestimation by our structural models may not stem from their inability to properly account for default risk, but rather from the importance of the omitted risk factors.

Keywords: Credit risk, credit derivatives, corporate bonds, structural models

JEL Classification: G12, G13

Suggested Citation

Ericsson, Jan and Reneby, Joel and Wang, Hao, Can Structural Models Price Default Risk? New Evidence from Bond and Credit Derivative Markets (January 27, 2005). EFA 2005 Moscow Meetings Paper, Available at SSRN: https://ssrn.com/abstract=637042 or http://dx.doi.org/10.2139/ssrn.637042

Jan Ericsson (Contact Author)

McGill University ( email )

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Swedish Institute for Financial Research (SIFR)

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Joel Reneby

Stockholm School of Economics - Department of Finance ( email )

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Hao Wang

Tsinghua University ( email )

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China
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