### Abstract

Original language | English |
---|---|

Pages (from-to) | 2049-2094 |

Journal | The Review of Financial Studies |

Volume | 26 |

Issue number | 8 |

Publication status | Published - 2013 |

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*The Review of Financial Studies*,

*26*(8), 2049-2094.

}

*The Review of Financial Studies*, vol. 26, no. 8, pp. 2049-2094.

**Pricing credit default swaps with observable covariates.** / Doshi, H.; Ericsson, J.; Jacobs, K.; Turnbull, S.

Research output: Contribution to journal › Article › Scientific › peer-review

TY - JOUR

T1 - Pricing credit default swaps with observable covariates

AU - Doshi, H.

AU - Ericsson, J.

AU - Jacobs, K.

AU - Turnbull, S.

PY - 2013

Y1 - 2013

N2 - Observable covariates are useful for predicting default, but several studies question their value for explaining credit spreads. We introduce a discrete-time no-arbitrage model with observable covariates, which allows for a closed-form solution for the value of credit default swaps (CDS). The default intensity is a quadratic function of the covariates, specified such that it is always positive. The model yields economically plausible results in terms of fit, the economic impact of the covariates, and the prices of risk. Risk premiums are large and account for a smaller percentage of spreads for firms with lower credit quality. Macroeconomic and firm-specific information can explain most of the variation in CDS spreads over time and across firms, even with a parsimonious specification. These findings resolve the existing disconnect in the literature regarding the value of observable covariates for credit risk pricing and default prediction.

AB - Observable covariates are useful for predicting default, but several studies question their value for explaining credit spreads. We introduce a discrete-time no-arbitrage model with observable covariates, which allows for a closed-form solution for the value of credit default swaps (CDS). The default intensity is a quadratic function of the covariates, specified such that it is always positive. The model yields economically plausible results in terms of fit, the economic impact of the covariates, and the prices of risk. Risk premiums are large and account for a smaller percentage of spreads for firms with lower credit quality. Macroeconomic and firm-specific information can explain most of the variation in CDS spreads over time and across firms, even with a parsimonious specification. These findings resolve the existing disconnect in the literature regarding the value of observable covariates for credit risk pricing and default prediction.

M3 - Article

VL - 26

SP - 2049

EP - 2094

JO - The Review of Financial Studies

JF - The Review of Financial Studies

SN - 0893-9454

IS - 8

ER -