Finance and Economics Discussion Series (FEDS)
July 1997
Estimating the Price of Default Risk
Gregory R. Duffee
Abstract:
A firm's instantaneous probability of default is modeled as a square-root diffusion process. The parameters of these processes are estimated for 188 firms, using both the time series and cross-sectional (term structure) properties of the individual firms' bond prices. Although the estimated models are moderately successful at bond pricing, there is strong evidence of misspecification. The results indicate that single factor models of instantaneous default risk face a significant challenge in matching certain key features of actual corporate bond yield spreads. In particular, such models have difficulty generating both relatively flat yield spreads when firms have low credit risk and steeper yield spreads when firms have higher credit risk.
Full paper (1053 KB Postscript)Keywords: Term structure, credit risk, credit ratings, corporate bonds, credit derivatives
PDF: Full Paper
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