Implied probabilities of default from Colombian money market spreads: The Merton Model under equity market informational constraints
AbstractInformational constraints may turn the Merton Model for corporate credit risk impractical. Applying this framework to the Colombian financial sector is limited to four stock-market-listed firms; more than a hundred banking and non-banking firms are not listed. Within the same framework, firms’ debt spread over the risk-free rate may be considered as the market value of the sold put option that makes risky debt trade below default-risk-free debt. In this sense, under some supplementary but reasonable assumptions, this paper uses money market spreads implicit in sell/buy backs to infer default probabilities for local financial firms. Results comprise a richer set of (38) banking and non-banking firms. As expected, default probabilities are non-negligible, where the ratio of default-probability-to-leverage is lower for firms with access to lender-of-last-resort facilities. The approach is valuable since it allows for inferring forward-looking default probabilities in the absence of stock prices. Yet, two issues may limit the validity of results to serial and cross-section analysis: overvaluation of default probabilities due to (i) spreads containing non-credit risk factors, and (ii) systematic undervaluation of the firm’s value. However, cross-section assessments of default probabilities within a wider range of firms are vital for financial authorities’ decision making, and represent a major improvement in the implementation of the Merton Model in absence of equity market data.
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Bibliographic InfoPaper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 743.
Date of creation: Oct 2012
Date of revision:
Merton model; structural model; credit risk; probability of default; distance to default. Classification JEL: G2; G13; G33; G32;
Other versions of this item:
- Carlos León, 2012. "Implied probabilities of default from Colombian money market spreads: The Merton Model under equity market informational constraints," BORRADORES DE ECONOMIA 010075, BANCO DE LA REPÚBLICA.
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