A Guide to Modeling Credit Term Structures

TL;DR

This paper reviews credit term structure modeling, critiques conventional approaches, and proposes survival-based methodologies aligned with market data, including empirical estimation and hedging strategies.

Contribution

It introduces survival-based valuation methods and alternative credit structure models that better fit market observations compared to traditional approaches.

Findings

Conventional models are equivalent to fractional recovery of market value, which market data does not support.

Survival-based models with fractional recovery of par better align with observed prices.

A new measure of CDS-Bond basis is proposed, linking to static hedging strategies.

Abstract

We give a comprehensive review of credit term structure modeling methodologies. The conventional approach to modeling credit term structure is summarized and shown to be equivalent to a particular type of the reduced form credit risk model, the fractional recovery of market value approach. We argue that the corporate practice and market observations do not support this approach. The more appropriate assumption is the fractional recovery of par, which explicitly violates the strippable cash flow valuation assumption that is necessary for the conventional credit term structure definitions to hold. We formulate the survival-based valuation methodology and give alternative specifications for various credit term structures that are consistent with market observations, and show how they can be empirically estimated from the observable prices. We rederive the credit triangle relationship by considering the replication of recovery swaps. We complete the exposition by presenting a consistent measure of CDS-Bond basis and demonstrate its relation to a static hedging strategy, which remains valid for non-par bonds and non-flat term structures of interest rates and credit risk.