TAILIEUCHUNG - Is Default Event Risk Priced in Corporate Bonds?

In this paper, we distinguish the risk of credit spread changes, if no default occurs, and the risk of the default event itself. We use credit spread data of many different firms and historical default rates to estimate the size of the default jump risk premium, along with the risk prices of credit spread changes. We show that, in order to fully explain the size of expected excess corporate bond returns, an economically and statistically significant default jump risk premium is necessary, on top of the risk premia that are due to the risk of credit spread changes | Is Default Event Risk Priced in Corporate Bonds Joost Driessen University of Amsterdam This Version March 2002 I thank Frank De Jong Siem-Jan Koopman Bertrand Melenberg Theo Nijman Kenneth Singleton and an anonymous referee for many helpful comments and suggestions. I also thank seminar participants at the 2001 ESSFM meeting in Gerzensee INSEAD Tilburg University the Tinbergen Institute NIB Capital Management and ABN-AMRO Bank for their comments. This is a revision of an earlier paper that was titled The Cross-Firm Behaviour of Credit Spread Term Structures . Joost Driessen Finance Group Faculty of Economics and Econometrics University of Amsterdam Roetersstraat 11 1018 WB Amsterdam The Netherlands. Tel 31-20-5255263. E-mail jdriess@. Is Default Event Risk Priced in Corporate Bonds Abstract We identify and estimate the sources of risk that cause corporate bonds to earn an excess return over default-free bonds. In particular we estimate the risk premium associated with a default event. Default is modelled using a jump process with stochastic intensity. For a large set of firms we model the default intensity of each firm as a function of common and firm-specific factors. In the model corporate bond excess returns can be due to risk premia on factors driving the intensities and due to a risk premium on the default jump risk. The model is estimated using data on corporate bond prices for 104 US firms and historical default rate data. We find significant risk premia on the factors that drive intensities. However these risk premia cannot fully explain the size of corporate bond excess returns. Next we estimate the size of the default jump risk premium correcting for possible tax and liquidity effects. The estimates show that this event risk premium is a significant and economically important determinant of excess corporate bond returns. JEL Codes E43 G12 G13. Keywords Credit Spread Default Event Corporate Bond Credit Derivative Intensity Models. 1 Introduction

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