Date of Original Version

12-28-2006

Type

Article

Published In

Stochastic Processes and their Applications Volume 117, Issue 11, November 2007, Pages 1724-1749

Rights Management

http://dx.doi.org/10.1016/j.spa.2007.01.013

Abstract or Table of Contents

This paper estimates the price for restructuring risk in the U.S. corporate bond market during 1999-2005. Comparing quotes from default swap (CDS) contracts with a restructuring event and without, we find that the average premium for restructuring risk represents 6% to 8% of the swap rate without restructuring. We show that the restructuring premium depends on firmspecific balance-sheet and macroeconomic variables. And, when default swap rates without a restructuring event increase, the increase in restructuring premia is higher for low-credit-quality firms than for high-credit-quality firms. We propose a reduced-form arbitrage-free model for pricing default swaps that explicitly incorporates the distinction between restructuring and default events. A case study illustrating the model’s implementation is provided.