ABSTRACT
To our knowledge, this contribution is the first to study the Hull and White (2000) model’s empirical performance based on a broad sample of liquid CDS-spread quotes. The model’s attractiveness as a reduced form approach is that it can be implemented based on observable market data. We use both the standard and the approximate Hull-White pricing approach. The standard intensity-based no-arbitrage approach requires data from at least three corresponding liquid corporate bonds. The approximate no-arbitrage approach requires data from two corresponding liquid corporate bonds. Using an overall of 63,460 quotes during the period January 1, 2002 to July 7, 2006, we study 47 names in the standard pricing approach and 64 names in the approximate pricing approach, all from the Dow Jones CDX North America Investment Grade (DJ CDX.NA.IG) index universe. We evaluate the pricing performance using spread change correlations and squared relative pricing errors. Given that liquid bond data with appropriate maturities are available for the respective companies, both approaches provide satisfying result as measured by spread change correlations and squared relative pricing errors. Confirming previous results by Houweling and Vorst (2005), we find that swap rather than Treasury rates should be used as a proxy for the risk-free rate. Tests on cointegration of Hull-White model and market spreads show that a stable pricing relationship is present for about 75% of our sample companies, while the model faces seriously weak performance for the remainder cases.
