There is a large and growing literature on how to model the dynamics of the default-free term structure to fit the observed historical data. Much less is known about how best to model the dynamics of defaultable yield curves. This paper develops a class of defaultable term structure models that is tractable enough to be empirically implemented and flexible enough to capture some important behaviors of the credit spreads in the data. We compare two non-nested models within this class using a Bayesian estimation technique, which helps to solve the problem of latent state variables. The Bayesian approach also enables us to test the two non-nested models on the basis of the Bayes factor. The results strongly suggest that models with constant transition probabilities will not be able to fit the observed dynamics of inter-rating spreads.

In this paper we analyze the optimal contract for a portfolio manager who can exert effort to improve the quality of a private signal about future market prices. We assume complete markets over states distinguished by asset payoffs and place no restrictions on the form of the contract. We show that trading restrictions are essential because they prevent the manager from undoing the incentive effects of performance-based fees. We provide conditions under which simple benchmarking emerges as optimal compensation. Additional incentives to take risk are necessary when information can be manipulated or else the manager will understate information to offset the benchmarking.