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: Caisse de Dépôt et Placement du Québec
Mathieu Maurice: Caisse de Dépôt et Placement du Québec
Jean-Guy Simonato: HEC Montréal, Department of Finance

No 10-6, 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 that can be explained by factors such as the possibility of default, liquidity, tax differentials and market risk. We contribute to this literature by assessing the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion of 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 as well as credit default swap premia. The model is calibrated with consumption, inflation, risk-free yields and default data for Aa, A and Baa bonds from the 1987-2008 period. We find that our macroeconomic factors are linked with two out of three sharp increases in the spreads during this sample period, indicating that the variations can be related to macroeconomic undiversifiable risk. The estimated default spreads can explain almost half of the 10 years to maturity industrial Baa zero-coupon yields in some regime. Much smaller proportions are found for Aa and A bonds with numbers around 10%. The proportions of default estimated with credit default swaps are higher, in many cases doubling those found with corporate yield spreads.

Keywords: Credit spread; default spread; Markov switching; macroeconomic factors; reduced form model of default; random subjective discount factor; credit default swap; CDS (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2010-11-01
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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 (2007)
Working Paper: A reduced form model of default spreads with Markov switching macroeconomic factors (2007)
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