Risk aversion and the yield of corporate debt

This paper develops a model to estimate the implied default probability of corporate bonds. The model explicitly considers the risk averse behavior of investors to provide a more precise framework for estimating the implied default probability. A Kalman filter method is used to estimate time-varying risk premium associated with the investor's risk aversion. The results of nonlinear regressions indicate that previous risk-neutrality models consistently overestimate the implied default rates of corporate bonds. The results also suggest that investors may have been adequately compensated for investment in risky bonds.