Implied probabilities of default from Colombian money market spreads: The Merton Model under equity market informational constraints

Carlos León

Borradores de Economia from Banco de la Republica de Colombia

Abstract: Informational constraints may turn the Merton Model for corporate credit risk impractical. Applying this framework to the Colombian financial sector is limited to four stock-market-listed firms; more than a hundred banking and non-banking firms are not listed. Within the same framework, firms’ debt spread over the risk-free rate may be considered as the market value of the sold put option that makes risky debt trade below default-risk-free debt. In this sense, under some supplementary but reasonable assumptions, this paper uses money market spreads implicit in sell/buy backs to infer default probabilities for local financial firms. Results comprise a richer set of (38) banking and non-banking firms. As expected, default probabilities are non-negligible, where the ratio of default-probability-to-leverage is lower for firms with access to lender-of-last-resort facilities. The approach is valuable since it allows for inferring forward-looking default probabilities in the absence of stock prices. Yet, two issues may limit the validity of results to serial and cross-section analysis: overvaluation of default probabilities due to (i) spreads containing non-credit risk factors, and (ii) systematic undervaluation of the firm’s value. However, cross-section assessments of default probabilities within a wider range of firms are vital for financial authorities’ decision making, and represent a major improvement in the implementation of the Merton Model in absence of equity market data.

Keywords: Merton model; structural model; credit risk; probability of default; distance to default. (search for similar items in EconPapers)
JEL-codes: G13 G2 G32 G33 (search for similar items in EconPapers)
Pages: 36
Date: 2012-10
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (4)

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Working Paper: Implied probabilities of default from Colombian money market spreads: The Merton Model under equity market informational constraints (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:bdr:borrec:743

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