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A Simple Continuous Measure of Credit Risk

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Author Info

  • Byström, Hans

    ()
    (Department of Economics, Lund University)

  • Kwon, Oh Kang

    (Department of Finance)

Abstract

This paper introduces a simple continuous measure of credit risk that associates to each firm a risk parameter related to the firm's risk-neutral default intensity. These parameters can be computed from quoted bond prices and allow assignment of credit ratings much finer than those provided by various rating agencies. We estimate the risk measures on a daily basis for a sample of US firms and compare them with the corresponding ratings provided by Moody's and the distance to default measures calculated using the Merton (1974) model. The three measures group the sample of firms into various risk classes in a similar but far from identical way, possibly reflecting the models' different forecasting horizons. Among the three measures, the highest rank correlation is found between our continuous measure and Moody's ratings. The techniques in this paper can be used to extract the entire distribution of inter-temporal risk-neutral default intensities which is useful for time-to-default estimations as well as for pricing credit derivatives.

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Bibliographic Info

Paper provided by Lund University, Department of Economics in its series Working Papers with number 2003:14.

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Length: 18 pages
Date of creation: 24 Oct 2003
Date of revision: 18 Jan 2005
Publication status: Published in International Review of Financial Analysis, 2007, pages 508-523.
Handle: RePEc:hhs:lunewp:2003_014

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Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund,Sweden
Phone: +46 +46 222 0000
Fax: +46 +46 2224613
Web page: http://www.nek.lu.se/en
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Keywords: credit risk; credit rating; corporate bonds;

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References

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  1. Oh-Kang Kwon, 2002. "A General Framework for the Construction and the Smoothing of Forward Rate Curves," Research Paper Series 73, Quantitative Finance Research Centre, University of Technology, Sydney.
  2. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  3. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  4. Bolder, David & Streliski, David, 1999. "Yield Curve Modelling at the Bank of Canada," Technical Reports 84, Bank of Canada.
  5. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  6. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
  7. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
  8. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  9. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, vol. 53(6), pages 2225-2241, December.
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Cited by:
  1. Carl Chiarella & Christina Nikitopoulos Sklibosios & Erik Schlögl, 2007. "A Markovian Defaultable Term Structure Model With State Dependent Volatilities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(01), pages 155-202.
  2. Christina Nikitopoulos-Sklibosios, 2005. "A Class of Markovian Models for the Term Structure of Interest Rates Under Jump-Diffusions," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 6.

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