TIME-SERIES ESTIMATION OF THE BOND DEFAULT RISK PREMIUM

The bond default risk premium, measured by the spread between higher a nd lower grade bond returns, is often estimated with univariate time s eries procedures and used as an input in financial models. In this pap er, time series properties of the historical default risk premium are analyzed and forecasting results fi om univariate time series models a re compared. An autoregressive model with an overreaction component pr ovides the best statistical fit for the bond default risk premium seri es. A random walk model exhibits the worst fit. The findings are robus t over a variety of model specifications and measurement choices. For all forms of the time series process the univariate time series models explain a small percentage of the variation in the default risk premi um, raising questions about traditional approaches to estimating the e xpected default risk premium.