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Estimating the Structural Credit Risk Model When Equity Prices Are Contaminated by Trading Noises

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  • Duan, Jin-Chuan

    ()
    (Rotman School of Management, University of Toronto)

  • Fulop, Andras

    ()
    (ESSEC Business School)

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    Abstract

    The transformed-data maximum likelihood estimation (MLE) method for structural credit risk models developed by Duan (1994) is extended to account for the fact that observed equity prices may have been contaminated by trading noises. With the presence of trading noises, the likelihood function based on the observed equity prices can only be evaluated via some nonlinear filtering scheme. We devise a particle filtering algorithm that is practical for conducting the MLE estimation of the structural credit risk model of Merton (1974). We implement the method on the Dow Jones 30 firms and on 100 randomly selected firms, and find that ignoring trading noises can lead to significantly over-estimating the firm’s asset volatility. The estimated magnitude of trading noise is in line with the direction that a firm’s liquidity will predict based on three common liquidity proxies. A simulation study is then conducted to ascertain the performance of the estimation method.

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    Bibliographic Info

    Paper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number DR 06015.

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    Length: 30 pages
    Date of creation: Oct 2006
    Date of revision:
    Handle: RePEc:ebg:essewp:dr-06015

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    Postal: ESSEC Research Center, BP 105, 95021 Cergy, France
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    Web page: http://www.essec.edu/
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    Related research

    Keywords: Credit Risk; Maximum Likelihood; Microstructure; Option Pricing; Particle Filtering;

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    14. Duan, Jin-Chuan & Yu, Min-Teh, 1995. "Assessing the cost of Taiwan's deposit insurance," Pacific-Basin Finance Journal, Elsevier, vol. 3(1), pages 139-139, May.
    15. Ananth Madhavan & Matthew Richardson & Mark Roomans, 1996. "Why Do Security Prices Change? A Transaction-Level Analysis of NYSE Stocks," New York University, Leonard N. Stern School Finance Department Working Paper Seires 96-34, New York University, Leonard N. Stern School of Business-.
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    17. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    18. Gourieroux,Christian & Monfort,Alain, 1995. "Statistics and Econometric Models," Cambridge Books, Cambridge University Press, number 9780521477444, April.
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    20. Bandi, Federico M. & Russell, Jeffrey R., 2006. "Separating microstructure noise from volatility," Journal of Financial Economics, Elsevier, vol. 79(3), pages 655-692, March.
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