The pricing of credit risk: Theory and evidence

This dissertation consists of tow Chapters.;Chapter One presents an analytical model of corporate discount bond prices. The critical assumption of the model is that the dynamics of the firm's debt ratio revert toward a long-term target debt ratio. Default is triggered at high values of the debt ratio. The model predicts that the levels of the credit spreads of long-term bonds are more sensitive to the firm's target debt ratio than to its current debt ratio. The case is the opposite for bonds with shorter maturities. The credit spreads predicted by the model are mean-reverting, which is consistent with the empirical evidence from Duffee (1998) and Tauren (1999). The model outperforms that of Longstaff and Schwartz (1995) on bonds from Boise Cascade Corporation.;Chapter Two compares alternative default-free bond pricing models in their abilities to price the credit risk of companies. The theoretical framework is the reduced-form approach of Duffie and Singleton (1999). The parameters of a CKLS (1992) type stochastic differential equation that describes the dynamics of the credit spreads on coupon bonds are estimated by using the GMM. The data are credit spreads of 112 coupon bonds from 26 companies over the period 1986--1994. The estimation takes into account biases toward mean reversion induced by the unit-root problem and survivorship. The findings support the Brennan and Schwartz (1980) model that implies credit spreads which are mean-reverting and lognormally distributed.