Specification Analysis of Structural Credit Risk Models*

Corporate bond valuation and hedging with stochastic interest rates and endogenous bankruptcy

Jingzhi Huang, Zhan Shi and Hao Zhou

Review of Finance, 2020, vol. 24, issue 1, 45-98

Abstract: Empirical studies of structural credit risk models so far are often based on calibration, rolling estimation, or regressions. This paper proposes a GMM-based method that allows us to estimate model parameters and test model-implied restrictions in a unified framework. We conduct a specification analysis of five representative structural models based on the proposed GMM procedure, using information from both equity volatility and the term structure of single-name credit default swap (CDS) spreads. Our test results strongly reject the Merton (1974) model and two diffusion-based models with a flat default boundary. The other two models, one with jumps and one with stationary leverage ratios, do improve the overall fit of CDS spreads and equity volatility. However, all five models have difficulty capturing the dynamic behavior of both equity volatility and CDS spreads, especially for investment-grade names. On the other hand, these models have a much better ability to explain the sensitivity of CDS spreads to equity returns.

Keywords: Structural credit risk models; GMM; Consistent specification analysis; Credit default swaps; CDS hedging; Jump-diffusion models; Stochastic asset volatility; Realized equity volatility (search for similar items in EconPapers)
JEL-codes: C51 C52 G12 G13 (search for similar items in EconPapers)
Date: 2020
References: Add references at CitEc
Citations: View citations in EconPapers (7)

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Working Paper: Specification analysis of structural credit risk models (2008)
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