Gurdip Bakshi (University of Maryland) Dilip Madan (University of Maryland) Frank Xiaoling Zhang (Morgan Stanley)
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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Article provided by University of Chicago Press in its journal Journal of Business.
Volume (Year): 79 (2006) Issue (Month): 4 (July) Pages: 1955-1988 Download reference. The following formats are available: HTML
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