Measuring Default Risk from Market Price

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Measuring Default Risk from Market Price
Multiple Periods Assume that the bond has only
one payment of 100 in T periods
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Measuring Default Risk from Market Price
Multiple Periods
Multiplying by (-1) and adding 1
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Measuring Default Risk from Market Price
Which can be rewritten as
CDRT is the Cumulative Default Rate at year T.
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Measuring Default Risk from Market Price
Assuming that the yield also reflects risk
premium
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Measuring Default Risk from Market Price
Numerical Example IBM 10-year zero coupon bond is
rated A. The bond is traded at 7 YTM and
Treasury 10-year zero coupon bond traded at 6
YTM. The recovery rate is 45. What is the
cumulative default rate for 10 years? What is the
average marginal default rate? The Cumulative
Default Rate (CDR) for 10 years is
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Measuring Default Risk from Market Price
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Measuring Default Risk from Market Price
According to SP data the 10-year CDR for A rated
bond is only 3.5. The deference induced by the
fact that a large part of the credit spread
reflects a risk premium. For instance, assume
that 0.7 out of the credit spread reflects a
risk premium. In this case the 10-year CDR is
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Measuring Default Risk from Equity Prices
The credit spread approach is only useful when
there is a good bond market data. In practice,
there are many countries that do not have a
developed bond market. In addition, the firm may
do not have publicly traded bond. In this case we
can use the firms stock price in order to
estimate the credit risk parameters