Price of Risk: Recent Evidence From Large Financials

Manmohan Singh and Karim Youssef

No 2010/190, IMF Working Papers from International Monetary Fund

Abstract: Probability of default (PD) measures have been widely used in estimating potential losses of, and contagion among, large financial institutions. In a period of financial stress however, the existing methods to compute PDs and generate loss estimates that may vary significantly. This paper discusses three issues that should be taken into account in using PD-based methodologies for loss or contagion analyses: (i) the use of - risk-neutral probabilities - vs. -real-world probabilities; - (ii) the divergence between movements in credit and equity markets during periods of financial stress; and (iii) the assumption of stochastic vs. fixed recovery for financial institutions’ assets. All three elements have nontrivial implications for providing an accurate estimate of default probabilities and associated losses as inputs for setting policies related to large banks in distress.

Keywords: WP; sc; risk neutrality assumption; Price of risk; risk-neutral probabilities; real-world probabilities; cheapest-to-deliver bonds; distance-to-distress; JPoD; LCFIs; CDS SpreadEquity market signal; equity market volatility; CDS spread; CDS SpreadEDF; Stock markets; Credit default swap; Credit; Securities markets; Global (search for similar items in EconPapers)
Pages: 12
Date: 2010-08-01
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Citations: View citations in EconPapers (1)

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