The Barra Credit Series: Forecasting Default in the Face of Uncertainty

Jan 1, 2003

We develop a structural model of default risk that incorporates the short-term uncertainty inherent in default events. It is based on the assumption of incomplete information: We take as a premise that bond investors are not certain about the true level of firm value that will trigger default. The coherent integration of structure and uncertainty is facilitated with compensators. Compensators form the infrastructure of a class of credit models that is broad enough to include traditional structural models, intensity-based models and a great deal more. We give several empirical examples that compare default probabilities and credit yield spreads forecast by our compensator model to the output of a Black & Cox (1976) model. We find that our compensator model reacts more quickly and, unlike traditional structural models, forecasts positive short-term credit spreads for firms that are in distress. We conclude by demonstrating the curious and thought-provoking fact that, while our model is predicated on the surprise nature of default, it does not admit a conditional default rate.