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Decoding Default Risk: A Review of Modeling Approaches, Findings, and Estimation Methods

Author

Listed:
  • Gurdip Bakshi

    (Fox School of Business, Temple University, Philadelphia, Pennsylvania, USA)

  • Xiaohui Gao

    (Fox School of Business, Temple University, Philadelphia, Pennsylvania, USA)

  • Zhaodong Zhong

    (Rutgers Business School, New Brunswick, New Jersey, USA)

Abstract

Default risk permeates the behavior of corporate bond returns and spreads, credit default swap spreads, estimation of default probabilities, and loss in default. Pertinent to this review are salient empirical findings and implications of default process estimation from 1974 to 2021. Both structural and reduced-form models are covered. In structural models, default occurs if the value of assets falls below some threshold obligation. The reduced-form models involve assumptions about the default process combined with recovery in default. Default process estimation and measurements of default probability have improved by exploiting data on defaultable bonds, credit default swaps, tally of default realizations, and options on individual equities. Empirical investigations continue to address the relevance of stochastic asset volatility, jumps in asset values, and modeling of default boundary and firm leverage process.

Suggested Citation

  • Gurdip Bakshi & Xiaohui Gao & Zhaodong Zhong, 2022. "Decoding Default Risk: A Review of Modeling Approaches, Findings, and Estimation Methods," Annual Review of Financial Economics, Annual Reviews, vol. 14(1), pages 391-413, November.
    • Handle: RePEc:anr:refeco:v:14:y:2022:p:391-413
    DOI: 10.1146/annurev-financial-111720-090709
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    Keywords

    default; default intensity-based credit risk models; empirical facts in credit markets; model estimation; recovery in default; structural models;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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