Estimating the price of default risk

A firm's instantaneous probability of default is modeled as a translated square-root diffusion process modified to allow the process to be correlated with default-free interest rates, The parameters of the process are estimated for 161 firms. An extended Kalman filter approach is used that incorporates both the time-series and cross-sectional (term structure) properties of the individual firms' bond prices. The model is reasonably successful at fitting corporate bond yields, while key features of the term structures of yield spreads are captured in the signs and magnitudes of the resulting parameter estimates.