From Default Probabilities to Credit Spreads: Credit risk models do explain market prices
by Stefan M. Denzler of Converium Ltd.,
June 25, 2005
Abstract: 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.
Keywords: credit risk modeling, default risk, credit spread, expected default frequency, actual default probability and risk-neutral default probability, bond pricing.
Published in: Finance Research Letters, Vol. 3, No. 2, (June 2006), pp. 79-95.