Default risk in bond and credit derivatives markets. (Q1880667)

Because the rising of the default risk and the large outstanding volume of credit contracts in recent years, this book re-examines the two models of default risk. The first one is the firm value model, which is derived by Merton using a stochastic differential equation approach. Default occurs when the value of the firm hits a certain boundary. This model has been well examined and empirically tested intensively. Many restrictive assumptions of the original model have been relaxed. This on one hand increases the applicability, on the other hand gives up much of their economic interpretability. The major focus of this book is on the second model: reduced-form model. The risk of the default is captured by a Poisson process whose first jump indicates the default. It further assumes a constant recovery rate. The author reviews the theoretic work: the defaultable bond prices can be derived when tax effects, the impact of regulatory and liquidity issues are ignored. The book centers on testing seven specifications of two-factor and three-factor Affine Term Structure Models (ATSM for short). All the factors follow independent Vasicek or CIR (Cox, Ingersoll and Ross) processes. Chapter 4 of the book does the empirical work. Daily quotes (March 1998 to October 2001) for bonds denominated in EUR(USD) which consists of 23(17) firms are collected, as well as the German and US government bonds are collected at OTC Dealer quotes from REUTERS. The author only considers senior unsecured bonds with maturity of greater than 180 days and without embedded options. First, the author estimates the firm specific defaultable term structures using Nelson and Siegel models; Secondly, it estimates the risk-free term structure using the Svensson model. Third, he tests completely ATSM for defaultable rates over limited time span. The author finds all preferred ATSM models for his sample firms. Fourth, he tests completely ATSM for default spreads. Fifth, he tests completely ATSM for defaultable rates allowing correlation between risk free rates and spread. The estimation tool is quasi-maximum likelihood via a Kalman filter recursion. Finally, he does a clinical study for the efficient ASTM. The tool is the efficient method of moments. In general, the author uses more data than others and he tests the above models using firm's specific term structure. Very few empirical analyses have been done on credit derivatives. The author adopts the model from Cambell and Taskler, and he focuses on the link between equity volatility and credit spreads. The tool is the regression analysis. Besides the historical volatility, the author also includes the option-implied volatility in explaining Credit Default Swap Premia. The book points out the limitation of his data and the tests. The author also argues that the difference in terms of economic intuition between the two classes of models, namely the firm value and the reduced-form models, is much smaller than one would expect based on the prevailing perception.