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Underpriced Default Spread Exacerbates Market Crashes

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Author Info

  • Winston T.H. Koh

    (SMU)

  • Roberto S. Mariano
  • Andrey Pavlovb
  • Sock Yong Phang
  • Augustine H. H. Tan
  • Susan M. Wachter

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.

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Bibliographic Info

Paper provided by East Asian Bureau of Economic Research in its series Finance Working Papers with number 22458.

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Date of creation: Jan 2006
Date of revision:
Handle: RePEc:eab:financ:22458

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Postal: JG Crawford Building #13, Asia Pacific School of Economics and Government, Australian National University, ACT 0200
Web page: http://www.eaber.org
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Related research

Keywords: real estate bubble; lender optimism; disaster myopia; Asian financial crisis;

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References

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  1. Richard J. Herring & Susan Wachter, 1999. "Real Estate Booms and Banking Busts: An International Perspective," Center for Financial Institutions Working Papers 99-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Jonathan McCarthy & Richard W. Peach, 2004. "Are home prices the next "bubble"?," Economic Policy Review, Federal Reserve Bank of New York, issue Dec, pages 1-17.
  3. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  4. Franklin Allen, 2001. "Presidential Address: Do Financial Institutions Matter?," Journal of Finance, American Finance Association, vol. 56(4), pages 1165-1175, 08.
  5. John Krainer & Chishen Wei, 2004. "House prices and fundamental value," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct1.
  6. Karl E. Case & Robert J. Shiller, 2003. "Is There a Bubble in the Housing Market?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(2), pages 299-362.
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Cited by:
  1. Andrey Pavlov & Susan Wachter, 2009. "Mortgage Put Options and Real Estate Markets," The Journal of Real Estate Finance and Economics, Springer, vol. 38(1), pages 89-103, January.
  2. Roberto S. Mariano, 2009. "Misaligned Incentives and Mortgage Lending in Asia," Working Papers 07-2009, Singapore Management University, School of Economics.

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