Investigating the Role of Systematic and Firm-Specific Factors in Default Risk: Lessons from Empirically Evaluating Credit Risk Models

Gurdip Bakshi, Dilip Madan and Frank Xiaoling Zhang
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Gurdip Bakshi: University of Maryland
Dilip Madan: University of Maryland
Frank Xiaoling Zhang: Morgan Stanley

Journal of Business, 2006, vol. 79, issue 4, pages 1955-1988

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 factor for firm-specific distress. The firm-specific distress factors 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 bond yields. When applied to low-grade bonds, a credit risk model that takes leverage into consideration reduces absolute yield mispricing by as much as 30%. A strategy relying on Treasury instruments is effective in dynamically hedging credit exposures.

Date: 2006
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