Bayesian corporate bond pricing and credit default swap premium models for deriving default probabilities and recovery rates

Abstract

This paper develops a Bayesian method by jointly formulating a corporate bond (CB) pricing model and credit default swap (CDS) premium pricing models to estimate the term structure of default probabilities and the recovery rate. These parameters are formulated by incorporating firm characteristics such as industry, credit rating and Balance Sheet/Profit and Loss information. A cross-sectional model valuing all given CB prices and CDS premiums is considered. The quantities derived are regarded as what market participants infer in forming CB prices and CDS premiums. We also develop a statistical significance test procedure without any distributional assumptions for the specified model. An empirical analysis is conducted using Japanese CB and CDS market data.

Keywords:

• Bayesian econometrics
• credit risk management
• default probability
• recovery rates

Acknowledgements

I thank the editor and anonymous reviewers for constructive and helpful comments that improved the quality of the paper considerably. This research was supported by the Nomura Foundation (Japan) and the Keio Gijuku Fukuzawa Memorial Fund for the Advancement of Education and Research.