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The Term Structure of Credit Risk: Estimates and Specification Tests

Listed author(s):
  • Robert E. Cumby
  • Martin D.D. Evans

This paper examines alternative methods for making inferences about the value and dynamics of (unobserved) credit quality from market prices. Using data on Brady bonds issued by Mexico, Venezuela, and Costa Rica, we show that estimates of credit quality from of a simple model (often used by practitioners) with a constant conditional probability of default are dynamically inconsistent; the market distinguishes between current and future credit quality. We then examine two models with this feautre. The first assumes that credit quality follows a diffusion process while the second assumes mean reverting dynmanics for credti quality. Although these models have very different implications for the asymptotic probability of default, we show that it is impossible to distinguish between them on the basis of the few years of high frequency data in our sample. We then examine the possible consequences for the pricing of new issues that can arise from the misspecification ! of the asymptotic probabilities.

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Paper provided by New York University, Leonard N. Stern School of Business, Department of Economics in its series Working Papers with number 95-14.

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Date of creation: Sep 1995
Handle: RePEc:ste:nystbu:95-14
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New York University, Leonard N. Stern School of Business, Department of Economics, 44 West 4th Street, New York, NY 10012-1126

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