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Estimating the Price of Default Risk

by Gregory R. Duffee of the Federal Reserve Board of Governors

Spring 1999

Abstract: A firm's instantaneous probability of default is modeled as a square-root diffusion process. The parameters of these processes are estimated for 188 firms, using both the time series and cross-sectional (term structure) properties of the individual firms' bond prices. Although the estimated models are moderately successful at bond pricing, there is strong evidence of misspecification. The results indicate that single factor models of instantaneous default risk face a significant challenge in matching certain key features of actual corporate bond yield spreads. In particular, such models have difficulty generating both relatively at yield spreads when firms have low credit risk and steeper yield spreads when firms have higher credit risk.

JEL Classification: G12, G13.

Keywords: term structure, credit risk, credit ratings, corporate bonds, credit derivatives.

Published in: Review of Financial Studies, Vol. 12, No. 1, (Spring 1999), pp. 197-226.

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