Empirical Evaluation of Hybrid Defaultable Bond Pricing Models

Abstract

A four‐factor model (the extended model of Schmid and Zagst) is presented for pricing credit risk related instruments such as defaultable bonds or credit derivatives. It is an advancement of an earlier three‐factor model. In addition to a firm‐specific credit risk factor, a new systematic risk factor in the form of GDP growth rate is included. This new model is set in the context of other hybrid defaultable bond pricing models and empirically compared to specific representatives. We find that a model based only on firm‐specific variables is unable to capture changes in credit spreads completely. However, it is shown that in this model, market variables such as GDP growth rates, non‐defaultable interest rates and firm‐specific variables together significantly influence credit spread levels and changes.

Acknowledgement

The authors would like to thank an anonymous referee for his valuable suggestions that improved the paper substantially.

Notes

1. Source: S & P Rating Transitions

2. The hypergeometric function, usually denoted by F, has series expansion

where (a)₀ = 1, (a) _n  = a(a+1)(a+2)…(a+n−1), n ∈ N, and is the solution of the hypergeometric differential equation

The hypergeometric function can be written as an integral

and is also known as the Gauss series or the Kummer series.