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Underpriced Default Spread Exacerbates Market Crashes

Winston Koh, Roberto Mariano (), Andrey Pavlovb, Sock-Yong Phang (), Augustine H. H. Tan and Susan Wachter ()

Finance Working Papers from East Asian Bureau of Economic Research

Abstract: In this paper, we develop a specific observable symptom of a banking system that underprices the default spread in non-recourse asset-backed lending. Using three different data sets for 18 countries and property types, we find that, following a negative demand shock, the underpricing economies experience far deeper asset market crashes than economies in which the put option is correctly priced. Furthermore, only one of the countries in our sample continues to exhibit the underpricing symptom following a market crash. This indicates that market crashes have a cleansing effect and eliminate underpricing at least for a period of time. This makes investing in such markets safer following a negative demand shock.

Keywords: real estate bubble; lender optimism; disaster myopia; Asian financial crisis (search for similar items in EconPapers)
JEL-codes: G01 L85 G21 (search for similar items in EconPapers)
Date: 2006-01
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