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

Research output: Contribution to journalArticlepeer-review

7 Scopus citations

Abstract

In this paper, I propose a general pricing framework that allows the risk neutral dynamics of loss given default (LQ) and default probabilities (λQ) to be separately and sequentially discovered. The key is to exploit the differentials in LQ exhibited by different securities on the same underlying firm. By using equity and option data, I show that one can efficiently extract pure measures of λQ that 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 associated LQ corresponding to that particular security. Using data on credit default swap premiums, I show that, cross-sectionally, λQ and LQ are positively correlated. In particular, this positive correlation is strongly driven by firms' characteristics, including leverage, volatility, profitability and q-ratio. For example, 1% increase in leverage leads to 0.14% increase in λQ and 0.60% increase in LQ.

Original languageEnglish (US)
Article number1550005
JournalQuarterly Journal of Finance
Volume5
Issue number1
DOIs
StatePublished - Mar 1 2015

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics
  • Strategy and Management

Fingerprint Dive into the research topics of 'Separating the Components of Default Risk: A Derivative-Based Approach'. Together they form a unique fingerprint.

Cite this