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I am currently in a project trying to quantify default risk premia for US Corporate Bonds. The data I have consists of bond prices, and other information (i.e. YTM, OAS, Effective Duration, Maturity etc.).The data includes bond prices with optionality and non-optionality. Now, I want to extract risk neutral default probabilities from the bonds at every point in time, but since the given prices incorporates possible optionalities , trying to quantify default risk premia from the extracted RN default probabilities (and comparing against real world DPs from another source) may not give me a true measure of the compensation for expected loss.

Now, the data also has information on option adjusted yields, or the yield of a bullet bond after stripping out the optionality. What I am thinking is to reprice the bonds using these option adjusted yields and then use those prices to extract risk neutral default probabilities.

My question is, will this be a prudent approach to take?

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  • $\begingroup$ You have OAS as a measure of credit risk. If you assume a recovery rate, from there you can get an hazard rate and then a default probability. Am I missing anything? $\endgroup$ – Lisa Ann Jun 3 at 20:14
  • $\begingroup$ Thanks, your suggested approach will be a good approximation under the assumption of constant intensity, however, I am trying to extract a term structure of DPs as opposed to a measure based on constant intensity. I could just use the prices given, but that would reflect embedded optionality. $\endgroup$ – Sheikh Sadik Jun 3 at 20:18
  • $\begingroup$ So you need an OAS curve/term structure for each issuer. Or a proxy for that. $\endgroup$ – Lisa Ann Jun 3 at 21:09
  • $\begingroup$ I do have OAS curves, but I am curious whether using these spreads to reprice bonds and extract RNDPs will be prudent? $\endgroup$ – Sheikh Sadik Jun 3 at 21:18

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