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Pricing the Risk of Default: Are Bonds Enough?

by Daniel Gomez of the University of Lausanne, and
Boris Nikolov of the University of Lausanne

October 19, 2003

Abstract: This paper implements a reduced form credit default swap (CDS) pricing model. Theoretical prices found are compared with market prices to evaluate the goodness of fit. Theoretical prices and pricing errors are inspected by rating classes, sectors of economic activity and currency denomination of CDS. Pricing errors are analyzed through panel data estimation techniques, to find determinants of pricing errors. These determinants could be used in theoretical pricing models as well as by practitioners when evaluating credit risk. Results suggest that debt market information is not enough for pricing credit risk and that equity markets have the potential for complementing credit pricing techniques.

JEL Classification: C23, G12, G13.

Keywords: Credit Derivatives, Credit Spreads, Credit Risk Pricing, Default Probability, Equity Markets.

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