From Default Probabilities to Credit Spreads: Credit Risk Models Do Explain Market Prices

18 Pages Posted: 7 Aug 2013

See all articles by Stefan Denzler

Stefan Denzler

Swiss Coordination Centre for Research in Education

Michel M. Dacorogna

DEAR-Consulting

Ulrich A. Müller

Olsen & Associates

Alexander McNeil

ETH Zürich - Department of Mathematics

Date Written: March 22, 2005

Abstract

Credit risk models like Moody's KMV are now well established in the market and give bond managers reliable estimates of default probabilities for individual firms. Until now it has been hard to relate those probabilities to the actual credit spreads observed on the market for corporate bonds. Inspired by the existence of scaling laws in financial markets by Dacorogna et al. (2001) and Di Matteo et al. (2005) deviating from the Gaussian behavior, we develop a model that quantitatively links those default probabilities to credit spreads (market prices). The main input quantities to this study are merely industry yield data of different times to maturity and expected default frequencies (EDFs) of Moody's KMV.

The empirical results of this paper clearly indicate that the model can be used to calculate approximate credit spreads (market prices) from EDFs, independent of the time to maturity and the industry sector under consideration. Moreover, the model is effective in an out-of-sample setting, it produces consistent results on the European bond market where data are scarce and can be adequately used to approximate credit spreads on the corporate level.

Keywords: credit risk modeling, default risk, credit spread, expected default frequency,actual default probability and risk-neutral default probability, bond pricing

JEL Classification: C15, C51, C52, C53, G12, G13

Suggested Citation

Denzler, Stefan and Dacorogna, Michel M. and Müller, Ulrich A. and McNeil, Alexander, From Default Probabilities to Credit Spreads: Credit Risk Models Do Explain Market Prices (March 22, 2005). Finance Research Letters, Vol. 3, No. 2, June 2006, Pages 79–95, Available at SSRN: https://ssrn.com/abstract=708941

Stefan Denzler

Swiss Coordination Centre for Research in Education ( email )

Francke-Gut
Entfelderstrasse 61
CH-5000 Aarau
Switzerland
+41 62 835 23 92 (Phone)
+41 62 835 23 99 (Fax)

HOME PAGE: http://www.skbf-csre.ch/portrait/personen/sd_en.html

Michel M. Dacorogna (Contact Author)

DEAR-Consulting ( email )

Scheuchzerstrasse 160
Zurich, 8057
Switzerland
+41795447327 (Phone)

Ulrich A. Müller

Olsen & Associates ( email )

Seefeldstrasse 233
CH-8008 Zurich
Switzerland
+41 (1) 386 48 16 (Phone)
+41 (1) 422 22 82 (Fax)

Alexander McNeil

ETH Zürich - Department of Mathematics ( email )

ETH Zentrum HG-F 42.1
Raemistr. 101
CH-8092 Zurich, 8092
Switzerland
+41 1 632 61 62 (Phone)
+41 1 632 10 85 (Fax)

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