The first paper, by Robert Jarrow, Xiaoming Wang, and Donald van Deventer, specifies a robust test of all single factor credit models that depend on the value of company assets for their predictive power. The second paper, by Xiaoming Wang and Donald van Deventer, focuses on a data base with more than 36,000 data points to determine whether movements of credit spreads and stock prices are consistent with the predictions of all single factor versions of the Merton model of risky debt. Both papers find that the Merton model is strongly rejected over the nine year time frame studied. Copies of both papers are available on the Kamakura research web page.
"Credit modeling is undergoing tremendous advances which will substantially improve the ability of major financial institutions and corporations to manage risk. Basel II requires extensive testing of these models, consistent with the highest standards of academic research," said Robert Jarrow, Managing Director of Research at Kamakura Corporation. "Only an extensive program of testing, combined with the rigor of the peer review found in the academic journals, provides bankers with an understanding of the risk reduction they can expect from the models they employ. We believe that the framework established by these two papers provides a solid basis for the testing of all credit models going forward, consistent with the objectives required under the Basel II process. We look forward to comments on the papers by regulators, financial market participants, and the academic community."