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.
Keywords: Term structure, credit risk, credit ratings, corporate bonds, credit derivatives
Full paper (721 KB PDF)
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