Do Macroeconomic Variables Matter for the Pricing of Default Risk? Evidence from the Residual Analysis of the Reduced-Form Model Pricing Errors

by Yan Alice Xie of the University of Michigan - Dearborn,
Chunchi Wu of Syracuse University, and
Jian Shi of Marshall University

September 8, 2004

Abstract: We apply a three-factor term structure framework that incorporates the correlation between default and spot rates to model the default process of corporate bonds. We find that there are missing factors in the traditional term structure model. The principal component analysis indicates that residuals of bonds across different ratings and maturities are driven by common factors. We find that macroeconomic variables, and the concurrent and lagged monthly return on S&P 500 index have significant explanatory power on the pricing errors. Results suggest that the pricing model of corporate bonds should incorporate the effect of macroeconomic factors.

Published in: International Review of Economics & Finance, Vol. 17, No. 2, (2008), pp. 279-291.

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