Can Structural Models Explain Prices of Sovereign Bonds?

36 Pages Posted: 14 Jun 2003

See all articles by R. Diana Diaz-Ledezma

R. Diana Diaz-Ledezma

Cass Business School of City University - Faculty of Finance

Gordon Gemmill

Warwick Business School

Date Written: June 2003

Abstract

We test the ability of an extended structural model, originally proposed by Cathcart and El-Jahel (2003), to capture the dynamics of prices for Mexican Brady bonds. In this framework, default is triggered either when a latent variable measuring financial distress falls below a specific threshold (as in structural models), or when a hazard rate causes an unexpected jump (as in reduced form models).

Using market prices and a Kalman Filter methodology, we estimate the model and extract the implicit "distance-to-default" over a seven-year period. The model is slightly superior to one which assumes that distance-to-default follows a random walk. However, the hazard-rate feature of the model makes no contribution to explaining the dynamics of market prices.

We find that three economic factors explain approximately 70% of the variation in the distance-to-default, namely: the level of the stock market, the exchange rate and the risk-free term structure. When the distance-to-default is approximated from these variables and substituted back into the models, the Cathcart and El-Jahel model still performs better than the naive model, not only in-sample but out-of-sample as well. The structural model is therefore supported over simpler alternatives, but only by a small margin.

Keywords: Structural Models, Distance-to-Default, Kalman Filter.

JEL Classification: G12

Suggested Citation

Diaz-Ledezma, R. Diana and Gemmill, Gordon, Can Structural Models Explain Prices of Sovereign Bonds? (June 2003). Data Not Availalbe, Cass Business School Research Paper, Available at SSRN: https://ssrn.com/abstract=393468 or http://dx.doi.org/10.2139/ssrn.393468

R. Diana Diaz-Ledezma (Contact Author)

Cass Business School of City University - Faculty of Finance ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
(44) (0) 207 040 8209 (Phone)
(44) (0) 207 040 8546 (Fax)

Gordon Gemmill

Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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