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Can Structural Models Price Default Risk? Evidence from Bond and Credit Derivative Markets

by Jan Ericsson of McGill University & SIFR,
Joel Reneby of the Stockholm School of Economics, and
Hao Wang of McGill University

April 10, 2006

Abstract: Using a set of structural models, we evaluate the price of default protection for a sample of US corporations. Credit default swaps (CDS) are commonly thought to be less influenced by non-default factors, making them an interesting source of data for evaluating models of default risk. In contrast to previous evidence from corporate bond data, CDS premia are not systematically underestimated. In fact, one of our studied models has little difficulty on average in predicting their level. For robustness, we perform the same exercise for bond spreads by the same issuers on the same trading date. As expected, bond spreads are systematically underestimated, consistent with their being driven by significant non-default components. Considering theoretical and market levels alone is insufficient to evaluate the models' performance, as other factors might be at play in both markets. With this in mind, we relate the models' residuals by means of linear regressions to default and non-default proxies. We find little evidence of any default risk component in either bond or CDS residuals. However, in the residuals for bonds, we find strong evidence for non-default components, in particular an illiquidity premium. CDS residuals reveal no such dependence. Taken together with our results on levels of bond spreads and CDS premia, this suggests that structural models are able to capture the credit risk priced in these markets and that they fail to price corporate bonds adequately due to omitted risks.

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