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Investigating the Role of Systematic and Firm-Specific Factors in Default Risk: Lessons from Empirically Evaluating Credit Risk Models

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Author Info

  • Gurdip Bakshi

    (University of Maryland)

  • Dilip Madan

    (University of Maryland)

  • Frank Xiaoling Zhang

    (Morgan Stanley)

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    Abstract

    This paper proposes and empirically investigates a family of credit risk models driven by a two-factor structure for the short interest rate and an additional factor for firm-specific distress. The firm-specific distress factors include leverage, book-to-market, profitability, equity-volatility, and distance-to-default. Our estimation approach and performance yardsticks show that interest rate risk is of first-order importance for explaining variations in single-name defaultable bond yields. When applied to low-grade bonds, a credit risk model that takes leverage into consideration reduces absolute yield mispricing by as much as 30%. A strategy relying on Treasury instruments is effective in dynamically hedging credit exposures.

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    Bibliographic Info

    Article provided by University of Chicago Press in its journal Journal of Business.

    Volume (Year): 79 (2006)
    Issue (Month): 4 (July)
    Pages: 1955-1988

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    Handle: RePEc:ucp:jnlbus:v:79:y:2006:i:4:p:1955-1988

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    Web page: http://www.journals.uchicago.edu/JB/

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    Cited by:
    1. Martijn Cremers & Joost Driessen & Pascal Maenhout & David Weinbaum, 2004. "Individual Stock-Option Prices and Credit Spreads," Yale School of Management Working Papers amz2391, Yale School of Management, revised 01 Jan 2005.
    2. Riedel, Christoph & Thuraisamy, Kannan S. & Wagner, Niklas, 2013. "Credit cycle dependent spread determinants in emerging sovereign debt markets," Emerging Markets Review, Elsevier, vol. 17(C), pages 209-223.
    3. Gündüz, Yalin & Uhrig-Homburg, Marliese, 2011. "Does modeling framework matter? A comparative study of structural and reduced-form models," Discussion Paper Series 2: Banking and Financial Studies 2011,05, Deutsche Bundesbank, Research Centre.
    4. Tang, Dragon Yongjun & Yan, Hong, 2008. "Market conditions, default risk and credit spreads," Discussion Paper Series 2: Banking and Financial Studies 2008,08, Deutsche Bundesbank, Research Centre.
    5. Carr, Peter & Wu, Liuren, 2007. "Theory and evidence on the dynamic interactions between sovereign credit default swaps and currency options," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2383-2403, August.
    6. repec:wyi:journl:002109 is not listed on IDEAS
    7. Kraft, Holger & Munk, Claus, 2007. "Bond durations: Corporates vs. Treasuries," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3720-3741, December.
    8. Anginer, Deniz & Yildizhan, Celim, 2010. "Is there a distress risk anomaly ? pricing of systematic default risk in the cross section of equity returns," Policy Research Working Paper Series 5319, The World Bank.
    9. Guarin, Alexander & Liu, Xiaoquan & Ng, Wing Lon, 2011. "Enhancing credit default swap valuation with meshfree methods," European Journal of Operational Research, Elsevier, vol. 214(3), pages 805-813, November.
    10. Peter Christoffersen & Du Du & Redouane Elkamhi, 2013. "Rare Disasters and Credit Market Puzzles," CREATES Research Papers 2013-45, School of Economics and Management, University of Aarhus.

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