A reduced form model of default spreads with Markov switching macroeconomic factors

Georges Dionne (), Geneviève Gauthier (), Khemais Hammami (), Mathieu Maurice and Jean-Guy Simonato ()
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Geneviève Gauthier: HEC Montreal, Department of Decision Sciences
Khemais Hammami: HEC Montreal, Canada Research Chair in Risk Management
Mathieu Maurice: Université de Montréal
Jean-Guy Simonato: HEC Montréal, Department of Finance

No 07-8, Working Papers from HEC Montreal, Canada Research Chair in Risk Management

Abstract: An important research area of the corporate yield spread literature seeks to measure the proportion of the spread explained by factors such as the possibility of default, liquidity or tax di§erentials. We contribute to this literature by assessing the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion in yield spreads caused by the risk of default in the context of a reduced form model. For this purpose, we extend the Markov switching risk-free term structure model of Bansal and Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond yields. The model is calibrated out of sample with consumption, ináation, risk-free yield and default data over the 1987-1996 period. Our results indicate that inflation is a key factor to consider for explaining default spreads during our sample period. We also find that that the estimated default spreads can explain up to half of the 10 year to maturity Baa zero-coupon yield in certain regime with different sensitivities to consumption and inflation through time.

Keywords: Credit spread; default spread; Markov switching; macroeconomic factors; reduced form model of default (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2007-10-01
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Related works:
Journal Article: A reduced form model of default spreads with Markov-switching macroeconomic factors (2011)
Working Paper: A Reduced Form Model of Default Spreads with Markov-Switching Macroeconomic Factors (2010)
Working Paper: A reduced form model of default spreads with Markov-switching macroeconomic factors (2010)
Working Paper: A Reduced Form Model of Default Spreads with Markov Switching Macroeconomic Factors (2007)
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