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

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  • Jin-Chuan Duan

    ()
    (School of Management, University of Toronto)

  • Andras Fulop

    ()
    (School of Management, University of Toronto)

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    Abstract

    The transformed-data maximum likelihood estimation (MLE) method for struc- tural 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. A simulation study is then conducted to ascertain the performance of the estimation method.

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    File URL: http://econ.core.hu/doc/dp/dp/mtdp0517.pdf
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    Bibliographic Info

    Paper provided by Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences in its series IEHAS Discussion Papers with number 0517.

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    Length: 30 pages
    Date of creation: 2005
    Date of revision:
    Handle: RePEc:has:discpr:0517

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    Related research

    Keywords: Particle filtering; maximum likelihood; option pricing; credit risk; simulation;

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    References

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    1. Yacine Ait-Sahalia & Per A. Mykland, 2003. "How Often to Sample a Continuous-Time Process in the Presence of Market Microstructure Noise," NBER Working Papers 9611, National Bureau of Economic Research, Inc.
    2. Harris, Lawrence, 1990. "Estimation of Stock Price Variances and Serial Covariances from Discrete Observations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(03), pages 291-306, September.
    3. Hasbrouck, Joel, 1993. "Assessing the Quality of a Security Market: A New Approach to Transaction-Cost Measurement," Review of Financial Studies, Society for Financial Studies, vol. 6(1), pages 191-212.
    4. Madhavan, Ananth & Richardson, Matthew & Roomans, Mark, 1997. "Why Do Security Prices Change? A Transaction-Level Analysis of NYSE Stocks," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1035-64.
    5. Jarrow, Robert A. & Turnbull, Stuart M., 2000. "The intersection of market and credit risk," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 271-299, January.
    6. Lehar, Alfred, 2005. "Measuring systemic risk: A risk management approach," Journal of Banking & Finance, Elsevier, vol. 29(10), pages 2577-2603, October.
    7. Duan, Jin-Chuan & Yu, Min-Teh, 1994. "Assessing the cost of Taiwan's deposit insurance," Pacific-Basin Finance Journal, Elsevier, vol. 2(1), pages 73-90, March.
    8. Duan, Jin-Chuan & Simonato, Jean-Guy, 2002. "Maximum likelihood estimation of deposit insurance value with interest rate risk," Journal of Empirical Finance, Elsevier, vol. 9(1), pages 109-132, January.
    9. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    10. Luc Laeven, 2002. "Bank Risk and Deposit Insurance," World Bank Economic Review, World Bank Group, vol. 16(1), pages 109-137, June.
    11. Ericsson, Jan & Reneby, Joel, 2003. "Valuing Corporate Liabilities," SIFR Research Report Series 15, Institute for Financial Research.
    12. Jin-Chuan Duan, 1994. "Maximum Likelihood Estimation Using Price Data Of The Derivative Contract," Mathematical Finance, Wiley Blackwell, vol. 4(2), pages 155-167.
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    Cited by:
    1. Georges Dionne & Sadok Laajimi & Sofiane Mejri & Madalina Petrescu, 2006. "Estimation of the Default Risk of Publicly Traded Canadian Companies," Cahiers de recherche 0613, CIRPEE.
    2. Abel Elizalde, 2006. "Credit Risk Models Ii: Structural Models," Working Papers wp2006_0606, CEMFI.

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