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Investigating the Role of Systematic and Firm-Specific Factors in Default Risk: Lessons from empirically evaluating credit risk models

by Gurdip Bakshi of the University of Maryland,
Dilip Madan of the University of Maryland, and
Frank Xiaoling Zhang of the Federal Reserve Board of Governors

July 2006

Abstract: This paper proposes and empirically investigates a family of credit risk models driven by a two-factor structure for the short-interest rate and an additional third factor for firm-specific distress, using the reduced-form framework of Duffie and Singleton (1999). The set of firm- specific distress factors analyzed in the study include leverage, book-to-market, profitability, equity-volatility, and distance-to-default. Our estimation approach and performance yardsticks show that interest rate risk is of first-order importance for explaining variations in single-name defaultable coupon bond yields and credit spreads. When applied to low-grade bonds, a credit risk model that takes leverage into consideration reduces absolute yield mispricing by as much as 30% relative to a competing model that ignores leverage. None of the distress factors improve performance for high-grade bonds. A strategy relying on traded Treasury instruments is surprisingly effective in dynamically hedging credit exposures for firms in our sample.

JEL Classification: G10, G11, G12.

Keywords: Default risk models, reduced-form, leverage, distance-to-default, hedging.

Published in: Journal of Business, Vol. 79, No. 4, (July 2006), pp. 1955-1988.

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