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Predicting and Pricing the Probability of Default

by Alessio A. Saretto of the University of California Los Angeles

August 4, 2004

Abstract: In this paper we study how corporate bond defaults can be predicted using financial ratios and how the forecasted probability of default relates to the cross-section of expected stock returns. Using several performance measures we find that the duration model outperforms existing models in correctly classifying both Default and Non-Default firms. Using the default probabilities predicted by our model, we analyze the relation between default risk and the Fama-French distress factors, HML and SMB. We find evidence that supports the interpretation on HML as a distress related factor. Both portfolio and individual stock factor loadings are related to the estimated default probabilities. We find a negative and significant contemporaneous correlation between HML and shocks to the level of aggregate financial distress.

JEL Classification: C41, G10, G33.

Keywords: Default, Hazard Rate, Distress Factors.

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