The Term Structure of Credit Risk: Estimates and Specification Tests

S-95-21

Posted: 9 Jul 1998

See all articles by Robert E. Cumby

Robert E. Cumby

Georgetown University - Department of Economics; National Bureau of Economic Research (NBER)

Martin D.D. Evans

Georgetown University - Department of Economics

Date Written: May 1995

Abstract

This paper examines alternative methods for making inferences about the value and dynamics of (unobserved) credit quality from market prices. Using data on Brady bonds issued by Mexico, Venezuela, and Costa Rica, we show that estimates of credit quality from of a simple model (often used by practitioners) with a constant conditional probability of default are dynamically inconsistent; the market distinguishes between current and future credit quality. We then examine two models with this feature. The first assumes that credit quality follows a diffusion process while the second assumes mean reverting dynamics for credit quality. Although these models have very different implications for the asymptotic probability of default, we show that it is impossible to distinguish between them on the basis of the few years of high frequency data in our sample. We then examine the possible consequences for the pricing of new issues that can arise from misspecification of the asymptotic probabilities.

JEL Classification: F30, F34

Suggested Citation

Cumby, Robert E. and Evans, Martin D.D., The Term Structure of Credit Risk: Estimates and Specification Tests (May 1995 ). S-95-21. Available at SSRN: https://ssrn.com/abstract=7155

Robert E. Cumby

Georgetown University - Department of Economics ( email )

580 Intercultural Center
Washington, DC 20057
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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Martin D.D. Evans (Contact Author)

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States
202-687-1570 (Phone)
202-687-6102 (Fax)

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