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Investigating the Role of Systematic and Firm-Specific Factors in Default Risk: Lessons from Empirically Evaluating Credit Risk Models

Author

Listed:
  • Gurdip Bakshi

    (University of Maryland)

  • Dilip Madan

    (University of Maryland)

  • Frank Xiaoling Zhang

    (Morgan Stanley)

Abstract

This paper proposes and empirically investigates a family of credit risk models driven by a two-factor structure for the short interest rate and an additional factor for firm-specific distress. The firm-specific distress factors include leverage, book-to-market, profitability, equity-volatility, and distance-to-default. Our estimation approach and performance yardsticks show that interest rate risk is of first-order importance for explaining variations in single-name defaultable bond yields. When applied to low-grade bonds, a credit risk model that takes leverage into consideration reduces absolute yield mispricing by as much as 30%. A strategy relying on Treasury instruments is effective in dynamically hedging credit exposures.

Suggested Citation

  • Gurdip Bakshi & Dilip Madan & Frank Xiaoling Zhang, 2006. "Investigating the Role of Systematic and Firm-Specific Factors in Default Risk: Lessons from Empirically Evaluating Credit Risk Models," The Journal of Business, University of Chicago Press, vol. 79(4), pages 1955-1988, July.
    • Handle: RePEc:ucp:jnlbus:v:79:y:2006:i:4:p:1955-1988
    DOI: 10.1086/503653
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