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Underpriced Default Spread Exacerbates Market Crashes

Winston Koh, Roberto Mariano (), Andrey Pavlov (), Sock-Yong Phang (), Augustine H. H. Tan () and Susan Wachter ()
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Andrey Pavlov: Simon Fraser University
Augustine H. H. Tan: School of Economics and Social Sciences, Singapore Management University

No 12-2006, Working Papers from Singapore Management University, School of Economics

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)
Pages: 32 pages
Date: 2006-03
New Economics Papers: this item is included in nep-ban, nep-fmk and nep-sea
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Published in SMU Economics and Statistics Working Paper Series

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