Asset liquidity, debt valuation and credit risk

Ethan Cohen-Cole ()

No QAU07-5, Supervisory Research and Analysis Working Papers from Federal Reserve Bank of Boston

Abstract: This paper presents a structural debt valuation model that links default probabilities and recovery rates of corporate securities to asset market liquidity. This linking is advantageous for risk management and regulation of financial institutions in that it provides a method of calibrating the relationship between probability of default (PD) and loss given default (LGD). Two innovations in the paper are the placing of the default point in a model of debt valuation into general equilibrium and conditioning this point on market factors such as asset liquidity. These allow one to derive implications on the correlation between various components of the model. Specifically, it finds two relationships between the probability of default (PD) and loss given default (LGD) of a debt instrument; temporal correlations are positive and cross-sectional ones negative. Such findings confirm the intuition of existing reduced form approaches and provide the ability to inspect other properties of the relationship that derive from theory. For example, one can use the model to forecast LGD. Some empirical validation of the theoretical results is provided.

Keywords: Securities; Default (Finance) (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://www.bostonfed.org/bankinfo/qau/wp/2007/qau0705.htm (text/html)
http://www.bostonfed.org/bankinfo/qau/wp/2007/qau0705.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedbqu:qau07-5

Ordering information: This working paper can be ordered from

Access Statistics for this paper

More papers in Supervisory Research and Analysis Working Papers from Federal Reserve Bank of Boston Contact information at EDIRC.
Bibliographic data for series maintained by Catherine Spozio ().