Structural models of credit risk predict that certain firm and market features (leverage, volatility, risk-free rates) determine the price of credit-risky bonds. Unlike previous empirical tests of structural models, we calibrate a model of Collin-Dufresne & Goldstein (2001) directly to bond prices. By augmenting the credit risk model with a specification of a liquidity discount, we obtain a very good fit and outperform a two-factor reduced form model. Further, a calibrated model of this type maintains benefits of typical structural models in that the framework provides predictions for the sensitivity of spreads to variables such as leverage ratios and risk-free rates. Generally, we understate the sensitivity towards changes in the leverage ratio and to a larger degree changes in the risk-free rates. For investment grade bonds the model attributes 40% of the yield spread at 5 years of maturity to credit risk, in some agreement with the literature.
By Søren Willemann