The goal of this paper is to extract the joint distribution of default probabilities and loss rates from the prices of credit default swaps and equity options. To this end, we estimate a structural model of credit risk with a representative agent with recursive preferences and Markov-switching states for the drift and volatility of consumption and earnings growth. While CDS rates are sensitive to both risk-neutral default probabilities and loss rates to bond holders, equity option prices are only sensitive to default probabilities because equity holders recovery almost nothing in bankruptcy. Using the information in both CDS rates and put option prices, we can recover the level and cyclicality of default probabilities, loss rates, and bankruptcy costs.
Presentations: 2017 University of Connecticut Annual Academic Conference on Risk Management, 2017 University of Minnesota Macro Asset Pricing Conference, 2017 FMA Conference on Derivatives and Volatility