Separating the Components of Default Risk: A Derivative-Based Approach

Anh Le ()
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Anh Le: UNC Kenan-Flagler Business School, McColl Building, CB 3490, Chapel Hill, NC 27599, United States

Quarterly Journal of Finance (QJF), 2015, vol. 05, issue 01, 1-48

Abstract: In this paper, I propose a general pricing framework that allows therisk neutraldynamics of loss given default(Lℚ)and default probabilities (λℚ) to be separately and sequentially discovered. The key is to exploit the differentials inLℚexhibited by different securities on the same underlying firm. By using equity and option data, I show that one can efficiently extract pure measures of λℚthat are not contaminated by recovery information. Equipped with this knowledge of pure default dynamics, prices of any defaultable security on the same firm with non-zero recovery can be inverted to compute the associatedLℚcorresponding to that particular security. Using data on credit default swap premiums, I show that, cross-sectionally, λℚandLℚare positively correlated. In particular, this positive correlation is strongly driven by firms' characteristics, including leverage, volatility, profitability andq-ratio. For example, 1% increase in leverage leads to 0.14% increase in λℚand 0.60% increase inLℚ.

Keywords: Default risk; loss given default; corporate bonds (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (8)

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DOI: 10.1142/S2010139215500056

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