From Default Probabilities To Credit Spreads: Credit Risk Models Do Explain Market Prices

Stefan Denzler, Michel Dacorogna, Ulrich A. Mueller and Alexander McNeil
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Stefan Denzler: ETH
Ulrich A. Mueller: Converium Ltd
Alexander McNeil: Swiss Federal Institute of Technology

Finance from University Library of Munich, Germany

Abstract: Credit risk models like Moody’s KMV are now well established in the market and give bond managers reliable estimates of default probabilities for individual firms. Until now it has been hard to relate those probabilities to the actual credit spreads observed on the market for corporate bonds. Inspired by the existence of scaling laws in financial markets by Dacorogna et al. (2001) and Di Matteo et al. (2005) deviating from the Gaussian behavior, we develop a model that quantitatively links those default probabilities to credit spreads (market prices). The main input quantities to this study are merely industry yield data of different times to maturity and expected default frequencies (EDFs) of Moody’s KMV. The empirical results of this paper clearly indicate that the model can be used to calculate approximate credit spreads (market prices) from EDFs, independent of the time to maturity and the industry sector under consideration. Moreover, the model is effective in an out-of-sample setting, it produces consistent results on the European bond market where data are scarce and can be adequately used to approximate credit spreads on the corporate level.

JEL-codes: C15 C51 C52 C53 G12 G13 (search for similar items in EconPapers)
Pages: 18 pages
Date: 2005-04-14
New Economics Papers: this item is included in nep-fin
Note: Type of Document - pdf; pages: 18
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Journal Article: From default probabilities to credit spreads: Credit risk models do explain market prices (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0504011

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