Estimating Default Risk Premia from Default Swap Rates and EDFs

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  • 1 January 2004
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      • Published in RePEc
Abstract
This paper estimates recent default risk premia for U.S. corporate debt, based on a close relationship between default probabilities, as estimated by the Moody’s KMV EDF measure, and market default swap (CDS) rates. The default-swap data, obtained by CIBC from a large number of dealers and bank counterparties, allows us to establish a strong link between actual and risk-neutral default probabilities for 69 firms in the three sectors that we analyzed: broadcasting and entertainment, healthcare, and oil and gas. Based on over 49,000 CDS rate quotes beginning September 2000, we find that five-year EDFs explain over 70% of the variation in daily five-year CDS rates, across all firms and days. Better explanatory power can be obtained by controlling for sectors and calendar periods. Our preliminary results suggest that, during our sample period, credit spreads widened by approximately 16 basis points for each additional 10 basis points of EDF, with adjustments that we shall describe for non-linearities and for variation across sectors and calendar quarters. If a given firm’s risk-neutral default intensity lambda* and risk-neutral expected fraction L* of notional lost at default are assumed to be relatively stable over time, the firm’s CDS rate and the par-coupon credit spread would be approximately equal to the risk-neutral mean loss rate, lambda*L*. The actual sample-mean of loss given default during our sample period was reported by Altman, Brady, Resti, and Sironi (2003) to be approximately 75%. Using 75% as a rough estimate for L*, our measured relationship between CDS and EDF implies that risk-neutral default intensities are roughly double actual default intensities (proxied by EDFs). This ratio of risk-neutral to actual default intensities is a default-timing risk premium whose measurement is a primary objective of our analysis. This simple factor-of-two estimate of the default risk premium does not consider: (i) the effect of random fluctuations in actual an

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