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Author:Bakshi, Gurdip 

Working Paper
Investigating the sources of default risk: lessons from empirically evaluating credit risk models
From a credit risk perspective, little is known about the distress factors -- economy-wide or firm-specific -- that are important in explaining variations in defaultable coupon yields. This paper proposes and empirically tests a family of credit risk models. Empirically, we find that firm-specific distress factors play a role (beyond treasuries) in explaining defaultable coupon bond yields. Credit risk models that take into consideration leverage and book-to-market are found to reduce out-of-sample yield fitting errors (for the majority of firms). Moreover, the empirical evidence suggests that interest rate risk may be of first-order prominence for pricing and hedging. Measured by both out-of-sample pricing and hedging errors, the credit risk models perform relatively better for high grade bonds. Controlling for credit rating, the model performance is generally superior for longer maturity bonds compared to its shorter maturity counterparts. Using equity as an instrument reduces hedging errors. This paper provides an empirical investigation of credit risk models using observable economic factors.
AUTHORS: Bakshi, Gurdip; Madan, Dilip B.; Zhang, Frank X.
DATE: 2001

Working Paper
Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates
This article presents a framework for modeling defaultable debt under alternative recovery conventions (for a wide class of processes describing recovery rates and default probability). These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be utilized to invert the market expectation of recovery rates implicit in bond prices. Among potential applications, the framework can be used for pricing and hedging credit derivatives that are contingent on the default event and/or recovery levels. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices. This article has attempted to model recovery and comprehend their impact on debt values.
AUTHORS: Bakshi, Gurdip; Madan, Dilip B.; Zhang, Frank X.
DATE: 2001

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