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A Simple Continuous Measure of Credit Risk

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  • 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.

Suggested Citation

  • Byström, Hans & Kwon, Oh Kang, 2003. "A Simple Continuous Measure of Credit Risk," Working Papers 2003:14, Lund University, Department of Economics, revised 18 Jan 2005.
    • Handle: RePEc:hhs:lunewp:2003_014
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    References listed on IDEAS

    as
    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. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453, World Scientific Publishing Co. Pte. Ltd..
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Leland, Hayne E & Toft, Klaus Bjerre, 1996. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    5. 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.
    6. 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 637-654, May-June.
    7. 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.
    8. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-489, October.
    9. David Bolder & David Stréliski, 1999. "Yield Curve Modelling at the Bank of Canada," Technical Reports 84, Bank of Canada.
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    Cited by:

    1. Aleksandra Wojcicka, 2012. "Calibration of a credit rating scale for Polish companies," Operations Research and Decisions, Wroclaw University of Technology, Institute of Organization and Management, vol. 3, pages 63-73.
    2. Su-Lien Lu, 2013. "Measuring credit risk by using a parameterized model under risk-neutral measure," Applied Economics Letters, Taylor & Francis Journals, vol. 20(8), pages 719-723, May.
    3. Mariusz Górajski & Dobromił Serwa & Zuzanna Wośko, 2019. "Measuring expected time to default under stress conditions for corporate loans," Empirical Economics, Springer, vol. 57(1), pages 31-52, July.
    4. 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.
    5. 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, July-Dece.
    6. Aleksandra Wojcicka-Wojtowicz, 2018. "Credit risk mangement in finance - a review of various approaches," Operations Research and Decisions, Wroclaw University of Technology, Institute of Organization and Management, vol. 4, pages 99-106.
    7. 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 1-2005.

    More about this item

    Keywords

    credit risk; credit rating; corporate bonds;

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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