Interactions Between Market and Credit Risk: Modeling the Joint Dynamics of Default-Free and Defaultable Bond Term Structures

The objective of this paper is to model and estimate simultaneously the joint dynamics of default-free and defaultable bond term structures. Defaultable bond prices are modeled in an intensity based framework along the lines of Duffie and Singleton (1999) with state variables following an affine diffusion. Our special interest lies in the benefits of introducing various kinds of interdependencies in the drifts and the diffusions of the factors driving the term structure dynamics. We obtain consistent and efficient estimates of the model parameters using the efficient method of moments (EMM) of Gallant and Tauchen (1996).