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From Default Probabilities To Credit Spreads: Credit Risk Models Do Explain Market Prices

  • Stefan Denzler

    (ETH)

  • Michel M. Dacorogna

    (Converium Ltd)

  • Ulrich A. Mueller

    (Converium Ltd)

  • Alexander McNeil

    (Swiss Federal Institute of Technology)

Credit risk models like Moody’s KMV are now well established in the market and give bond managers reliable estimates of default probabilities for individual firms. Until now it has been hard to relate those probabilities to the actual credit spreads observed on the market for corporate bonds. Inspired by the existence of scaling laws in financial markets by Dacorogna et al. (2001) and Di Matteo et al. (2005) deviating from the Gaussian behavior, we develop a model that quantitatively links those default probabilities to credit spreads (market prices). The main input quantities to this study are merely industry yield data of different times to maturity and expected default frequencies (EDFs) of Moody’s KMV. The empirical results of this paper clearly indicate that the model can be used to calculate approximate credit spreads (market prices) from EDFs, independent of the time to maturity and the industry sector under consideration. Moreover, the model is effective in an out-of-sample setting, it produces consistent results on the European bond market where data are scarce and can be adequately used to approximate credit spreads on the corporate level.

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File URL: http://128.118.178.162/eps/fin/papers/0504/0504011.pdf
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Paper provided by EconWPA in its series Finance with number 0504011.

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Length: 18 pages
Date of creation: 14 Apr 2005
Date of revision:
Handle: RePEc:wpa:wuwpfi:0504011
Note: Type of Document - pdf; pages: 18
Contact details of provider: Web page: http://128.118.178.162

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  1. Michel Dacorogna & Gianluca Oderda & Tobias Jung, 2003. "Credit Risk Models - Do They Deliver Their Promises? A Quantitative Assessment," Risk and Insurance 0306003, EconWPA.
  2. T. Di Matteo & T. Aste & Michel M. Dacorogna, 2005. "Long-term memories of developed and emerging markets: Using the scaling analysis to characterize their stage of development," Econometrics 0503004, EconWPA.
  3. 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.
  4. Acharya, Viral V & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.
  5. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, issue Oct.
  6. Delianedis, Gordon & Geske, Robert, 1998. "Credit Risk and Risk Neutral Default Probabilities: Information About Migrations and Defaults," University of California at Los Angeles, Anderson Graduate School of Management qt7dm2d31p, Anderson Graduate School of Management, UCLA.
  7. Muller, Ulrich A. & Dacorogna, Michel M. & Olsen, Richard B. & Pictet, Olivier V. & Schwarz, Matthias & Morgenegg, Claude, 1990. "Statistical study of foreign exchange rates, empirical evidence of a price change scaling law, and intraday analysis," Journal of Banking & Finance, Elsevier, vol. 14(6), pages 1189-1208, December.
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