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Probabilities of Default and the Market Price of Risk in a Distressed Economy

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  • Miguel A. Segoviano Basurto
  • Raphael A. Espinoza

Abstract

We propose an original method to estimate the market price of risk under stress, which is needed to correct for risk aversion the CDS-implied probabilities of distress. The method is based, for simplicity, on a one-factor asset pricing model. The market price of risk under stress (the expectation of the market price of risk, conditional on it exceeding a certain threshold) is computed from the price of risk (which is the variance of the market price of risk) and the discount factor (which is the inverse of the expected market price of risk). The threshold is endogenously determined so that the probability of the price of risk exceeding it is also the probability of distress of the asset. The price of risk can be estimated via different methods, for instance derived from the VIX or from the factors in a Fama-MacBeth regression.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 11/75.

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Length: 14
Date of creation: 01 Apr 2011
Date of revision:
Handle: RePEc:imf:imfwpa:11/75

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Related research

Keywords: Bankruptcy; Banks; Credit risk; Economic models; Risk premium; probability; probabilities; equation; probability of default; conditional expectation; bank for international settlements; standard deviation; normal distribution; bank of england; cumulative distribution function; correlation; linear regressions; calibrations; probability distribution;

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Cited by:
  1. Florence Bouvet & Ryan Brady & Sharmila King, 2013. "Debt Contagion in Europe: A Panel-Vector Autoregressive (VAR) Analysis," Social Sciences, MDPI, Open Access Journal, vol. 2(4), pages 318-340, December.
  2. Carlos Caceres & D. Filiz Unsal, 2013. "Sovereign Spreads and Contagion Risks in Asia," Asian Economic Journal, East Asian Economic Association, vol. 27(3), pages 219-243, 09.
  3. Gaston Giordana & Ingmar Schumacher, 2012. "An Empirical Study on the Impact of Basel III Standards on Banks? Default Risk: The Case of Luxembourg," BCL working papers 79, Central Bank of Luxembourg.
  4. Florence Bouvet & Ryan Brady & Sharmila King, 2013. "Debt Contagion in Europe: A Panel-VAR Analysis," Departmental Working Papers 44, United States Naval Academy Department of Economics.
  5. Miguel A. Segoviano Basurto & Carlos Caceres & Vincenzo Guzzo, 2010. "Sovereign Spreads," IMF Working Papers 10/120, International Monetary Fund.

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