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Implied probabilities of default from Colombian money market spreads: The Merton Model under equity market informational constraints

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  • Carlos León

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Abstract

Informational 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 Info

Paper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 743.

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Length: 36
Date of creation: Oct 2012
Date of revision:
Handle: RePEc:bdr:borrec:743

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Keywords: Merton model; structural model; credit risk; probability of default; distance to default. Classification JEL: G2; G13; G33; G32;

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References

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  1. Carlos León & Karen Leiton & Alejandro Reveiz, 2012. "Investment horizon dependent CAPM: Adjusting beta for long-term dependence," Borradores de Economia 730, Banco de la Republica de Colombia.
  2. Pamela A. Cardozo & Carlos A. Huertas C. & Julián A. Parra P. & Lina V. Patiño Echeverri, 2011. "Mercado interbancario colombiano y manejo de liquidez del Banco de la República," BORRADORES DE ECONOMIA 009017, BANCO DE LA REPÚBLICA.
  3. Carlos León Rincón & Alejandro Reveiz, 2011. "Montecarlo simulation of long-term dependent processes: a primer," BORRADORES DE ECONOMIA 008277, BANCO DE LA REPÚBLICA.
  4. Jhonatan Pérez Villalobos & Juan Carlos Mendoza Gutiérrez de Piñeres, . "Efecto día en el mercado accionario Colombiano: una aproximación no paramétrica," Borradores de Economia 585, Banco de la Republica de Colombia.
  5. Dumitru MATIS & Carmen Giorgiana BONACI, 2008. "Fair Value Accounting for Financial Instruments – Conceptual Approach and Implications," Timisoara Journal of Economics, West University of Timisoara, Romania, Faculty of Economics and Business Administration, vol. 1(2), pages 191-206.
  6. Kenneth French & Martin Baily & John Campbell & John Cochrane & Douglas Diamond & Darrell Duffie & Anil Kashyap & Frederic Mishkin & Raghuram Rajan & David Scharfstein & Robert Shiller & Hyun Song Shi, 2010. "The Squam Lake Report: Fixing the Financial System," Journal of Applied Corporate Finance, Morgan Stanley, vol. 22(3), pages 8-21.
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Cited by:
  1. Wilmar Cabrera & Adriana María Corredor-Waldron & Carlos Quicazán, . "Requerimientos Macroprudenciales de capital y riesgo sistémico: Una aplicación para Colombia," Temas de Estabilidad Financiera 074, Banco de la Republica de Colombia.

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