Quantification of the Impact of Default Risk on Credit Spreads: Quantification of the Impact of Default Risk on Credit Spreads - An Approach using Structural Models of Non-normal Returns

Abstract

We examine how much of the credit spreads is due to credit risk. A rich set of structural credit risk models incorporating economic assumptions such as stochastic volatility and jumps are implemented. The models are calibrated to match historical default frequencies and representative firm characteristics for different credit ratings. Using a new sample period, assumptions and parameters, we find support to previous studies that credit risk amounts for a small fraction of the credit spreads, especially for investment grade bonds. A discussion of choosing relevant parameters in the wedge between actual probabilities and risk-neutral probabilities is frequently evaluated as it potentially can alleviate this phenomena known as the credit spread puzzle.