The equity information and recovery rates are provided in Table 3. To
determine hazard rates, we need to know the observed market prices of
corporate bonds or CDS premia, as the market standard practice is to fit
the implied risk-neutral default intensities to these credit sensitive
instruments. The corporate bond prices are unfortunately not available
for companies X and Y , but their CDS premia are observable
as shown in Table 4. Usually the CDS market leads the bond market, in
particular during crisis situation. Liquidity in the bond market is
typically drying up during a financial crisis. Demand for insurance
against default risk, on the other hand, increases if the issuer is
experiencing financial stress. Consequently, prices and spreads derived
from the CDS market tend to be more reliable. Said differently, CDSs on
reference entities are often more actively traded than bonds issued by
the reference entities.
Unlike other studies that use bond spreads for pricing (see Tsiveriotis
and Fernandes (1998), Ammann, et al. (2003), Zabolotnyuk, et al. (2010),
etc.), we perform risky valuation based on credit information extracted
from CDS spreads. Given the recovery rates and the CDS premia, we can
compute the hazard rates via a standard calibration process (see J.P.
Morgan (2001)).