Exploring the Relationship Between Credit Spreads and Default Probabilities PDF Download

Author: Mark J. Manning
Publisher:
ISBN:
Category : Swaps (Finance)
Languages : en
Pages : 42

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Author: Heng-Chih Chou
Publisher:
ISBN:
Category :
Languages : en
Pages : 9

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This article analyzes the information content of the distance-from-default regarding a firm's default risk. Under the Merton's (1974) option pricing model, both the relation between the expected default probability of a firm and its distance-from-default, and the relation between the credit spreads and distance-from-default are examined. We demonstrate that both expected default probability and credit spreads could be expressed by the analytical function of the distance-from-default. This means that people can easily infer a firm's expected default probability and also its credit spreads from the information of the value of a firm's distance-from-default.

Author: Mr.Jorge A. Chan-Lau
Publisher: International Monetary Fund
ISBN: 1451852916
Category : Business & Economics
Languages : en
Pages : 21

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In reduced-form pricing models, it is usual to assume a fixed recovery rate to obtain the probability of default from credit default swap prices. An alternative credit risk measure is proposed here: the maximum recovery rate compatible with observed prices. The analysis of the recent debt crisis in Argentina using this methodology shows that the correlation between the maximum recovery rate and implied default probabilities turns negative in advance of the credit event realization. This empirical finding suggests that the maximum recovery rate can be used for constructing early warning indicators of financial distress.

Author: Nain
Publisher:
ISBN: 9783384262417
Category :
Languages : en
Pages : 0

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Author: Jing-Zhi Huang
Publisher:
ISBN:
Category :
Languages : en
Pages : 44

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A basic requirement for a credit risk model is that it should not imply negative default probabilities. In this paper, we explore the implications of this condition for credit risk modeling. More specifically, we use the condition as a diagnostic tool to investigate if a particular model is consistent with a given set of credit spreads. We show that under this condition, each model has two credit spread boundaries which can be calculated analytically, and the model is correctly specified if and only if the observed credit spread curve lies within the two boundaries. These analytical formulas for the boundaries also allow us to derive some general properties of a large class of credit risk models. Our study also adds to the literature on pricing defaultable claims off the default probability curve, a method widely used in practice. It is well-known that negative default probabilities frequently occur in constructions of default probability curves. Our analysis provides one possible explanation of why this problem happens and also suggests how the problem may be solved (or at least alleviated).

Author: David Lando
Publisher:
ISBN:
Category :
Languages : en
Pages :

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The term structure of interest rates contains information about the market's expectations of the direction of future interest rates. Similarly, the term structure of credit spreads contains information about the market's perception of future credit spreads. The term structure of credit spreads is closely linked with conditional default probabilities and this link suggests a downward sloping term structure of credit spreads for high risk issuers, whose default probability conditional on survival is likely to decrease. This paper shows that for sufficiently low credit quality, as defined by the level of credit spreads, this holds true most of the time when spreads are taken from credit default swap (CDS) markets. We also discuss why CDS markets give a better way of analyzing this problem than bond price data.

Author: Shu-Ying Lin
Publisher:
ISBN:
Category :
Languages : en
Pages : 31

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In a risk-neutral environment, credit spread has been regarded as a function of two variables, i.e., default probability and recovery rate. Once the recovery rate is determined, a spread can be employed to calculate implied default rate of a specific credit name. Most importantly, default correlation is not considered as a factor to determine the credit spread. However, recent development of credit basket market, e.g., Collateralized Debt Obligation (CDO) and credit tranching techniques have some impacts on financial markets. A new market called correlation trading has forced the credit spread to approach a new equilibrium based on default correlation. This research investigates the relationship between credit spread (of individual credit name) and default correlation (of a credit basket). CDS market data is employed to empirically test the correlation effect. The empirical results provide some evidence that correlation between individual name and market index influences mean spread on CDS.

Author: Myrteza Toro
Publisher:
ISBN:
Category : Economics
Languages : en
Pages : 0

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Author: Wouter Heynderickx
Publisher:
ISBN:
Category :
Languages : en
Pages : 19

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The relationship between the risk-neutral measure Q and the actual or real-world measure P, and the corresponding credit risk premium, are investigated in this paper. Quantifying and understanding the long-term average risk premium is important for a variety of financial applications and investment decision-making. This study develops an empirical analysis of this relationship, using CDS spreads of European corporates for estimating risk-neutral probabilities, and Moody's historical transition matrices to derive the corresponding actual values. Special attention is given to the recent financial crises and our study allows us to quantify its impact on risk premia. In line with some research based on pre-crisis data, we find that the ratio between the risk-neutral and actual default intensities, which we call the coverage ratio, is a convex and decreasing function of the actual default intensities. We are able to further differentiate between different time-horizons and conclude that current risk premia levels are still above their initial levels and this could indicate a permanent upward shift in risk premia. Finally, we link our results with the concept of Real Economic Value and its role in the bail-out of several European financial institutions.

Author: Qi Zhang
Publisher:
ISBN:
Category :
Languages : en
Pages : 306

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Exploring the main factors that determine bond spreads with respect to Treasury rates is one of the most critical issues in the corporate debt market. Credit risk has long been perceived as the most important determinant of bond spreads (Fisher, 1959). One of the most critical parameters in credit risk models is asset volatility, which includes idiosyncratic and systematic components. However, these models do not distinguish between them. Chapter 2 investigates the impact of idiosyncratic volatility on bond portfolio spreads between 2000 and 2010. While the prediction of traditional asset pricing models is that firm-specific risk should be diversified away at aggregate level, I find idiosyncratic volatility plays an incremental role in explaining bond portfolio spreads beyond the market factors. Recovery is an important measurement of credit risk additional to default probability. Chapter 3 focuses on the estimation of firm recovery after bankruptcy using the Leland and Toft (1996) model. Using a large sample of Chapter 11 filings from 1996 to 2007, I find that the recovery derived from the Leland and Toft model has strong explanatory power on the debt recovery observed in the market. Recent literature finds that all extant credit risk models significantly underestimate bond spreads, especially for investment grade bonds of short maturity. Chapter 4 identifies a heretofore ignored component, perceived accounting misstatement, by regressing bond spreads on the proxy of accounting misstatement propensity, while controlling for issuers' default risk and bond illiquidity risk between January 1994 and June 2002. My thesis deepens the understanding of bond price discovery mechanisms and presents an important challenge for future research to incorporate the strong empirical relationship between idiosyncratic volatility and bond yields in asset pricing models. My thesis also sheds light on the accurate prediction of debt recovery, which is important to the valuation and hedging of risky debt and credit derivatives. Furthermore, my thesis assists in solving the credit spread puzzle by identifying a new risk factor. Overall, my thesis provides new insights into research on the corporate debt market and has important implications for academic scholars and market practitioners.