Implied default barrier in credit default swap premia

Francisco Alonso (), Santiago Forte () and Jose Manuel Marqués Sevillano ()
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Francisco Alonso: Banco de España
Santiago Forte: ESADE - Universitat Ramon Llull

No 639, Banco de España Working Papers from Banco de España

Abstract: This paper applies the methodology developed by Forte and Peña (2006) to extract the implied default point in the premium on credit default swaps (CDS). As well as considering a more extensive international sample of corporations (96 US, European and Japanese companies) and a longer time interval (2001-2004), we make two significant contributions to the original methodology. First, we calibrate bankruptcy costs, allowing for the adjustment of the mean recovery rate of each sector to its historical average. Second, and drawing on the sample of default point indicators for each company-year obtained, we propose an econometric model for these indicators that excludes any reference to the credit derivatives market. With this model it is thus possible to estimate the default barrier resorting solely to the equity market. Compared with other alternatives for setting the default point in the absence of CDS (such as the optimal default point for shareholders, the default point in the Moody’s-KMV model or the face value of the debt), the out-of-sample use of the econometric model significantly improves the capacity of the structural model proposed by Forte and Peña (2006) to differentiate between companies with an investment grade rating (CDS less than 150 bp) and those with a non-investment grade rating.

Keywords: credit risk; structural model; credit default swap; implied default barrier (search for similar items in EconPapers)
JEL-codes: G13 G33 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-rmg
Date: 2006-12

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http://www.bde.es/informes/be/docs/dt0639e.pdf First English-language version, February 2007 (application/pdf)
http://www.bde.es/webbde/SES/Secciones/Publicacion ... jo/06/Fic/dt0639.pdf First Spanish-language version, January 2007 (application/pdf)

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Persistent link: http://EconPapers.repec.org/RePEc:bde:wpaper:0639

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