Can Structural Models Price Default Risk?
Evidence from Bond and Credit Derivative Marketsby Jan Ericsson of McGill University & SIFR, Joel Reneby of the Stockholm School of Economics, and Hao Wang of McGill University April 10, 2006 Abstract: Using a set of structural models, we evaluate the price of default protection for a sample of US corporations. Credit default swaps (CDS) are commonly thought to be less influenced by non-default factors, making them an interesting source of data for evaluating models of default risk. In contrast to previous evidence from corporate bond data, CDS premia are not systematically underestimated. In fact, one of our studied models has little difficulty on average in predicting their level. For robustness, we perform the same exercise for bond spreads by the same issuers on the same trading date. As expected, bond spreads are systematically underestimated, consistent with their being driven by significant non-default components. Considering theoretical and market levels alone is insufficient t
