Investigating the Role of Systematic and Firm-Specific Factors in Default Risk : Lessons from Empirically Evaluating Credit Risk Models

This paper proposes and empirically investigates a family of credit risk models driven by a two-factor structure for the short-interest rate and an additional third factor for firm-specific distress, using the reduced-form framework of Duffie and Singleton (1999). The set of firm-specific distress factors analyzed in the study include leverage, book-to-market, profitability, equity-volatility, and distance-to-default. Our estimation approach and performance yardsticks show that interest rate risk is of first-order importance for explaining variations in single-name defaultable coupon bond yields and credit spreads. When applied to low-grade bonds, a credit risk model that takes leverage into consideration reduces absolute yield mispricing by as much as 30% relative to a competing model that ignores leverage. None of the distress factors improve performance for high-grade bonds. A strategy relying on traded Treasury instruments is surprisingly effective in dynamically hedging credit exposures for firms in our sample