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Underpriced Default Spread Exacerbates Market Crashes

Author

Listed:
  • Winston T. H. Koh

    (School of Economics and Social Sciences, Singapore Management University)

  • Roberto S. Mariano

    (School of Economics and Social Sciences, Singapore Management University)

  • Andrey Pavlov

    (Simon Fraser University)

  • Sock Yong Phang

    (School of Economics and Social Sciences, Singapore Management University)

  • Augustine H. H. Tan

    (School of Economics and Social Sciences, Singapore Management University)

  • Susan M. Wachter

    (Department of Finance, The Wharton School, University of Pennsylvania)

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.

Suggested Citation

  • Winston T. H. Koh & Roberto S. Mariano & Andrey Pavlov & Sock Yong Phang & Augustine H. H. Tan & Susan M. Wachter, 2006. "Underpriced Default Spread Exacerbates Market Crashes," Working Papers 12-2006, Singapore Management University, School of Economics.
    • Handle: RePEc:siu:wpaper:12-2006
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    File URL: https://mercury.smu.edu.sg/rsrchpubupload/6692/underprice.pdf
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    References listed on IDEAS

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    1. Franklin Allen & Douglas Gale, 1999. "Innovations in Financial Services, Relationships, and Risk Sharing," Management Science, INFORMS, vol. 45(9), pages 1239-1253, September.
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    6. Franklin Allen, 2001. "Do Financial Institutions Matter?," Journal of Finance, American Finance Association, vol. 56(4), pages 1165-1175, August.
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    Cited by:

    1. Richard Green & Roberto Mariano & Andrey Pavlov & Susan Wachter, 2009. "Misaligned Incentives and Mortgage Lending in Asia," NBER Chapters, in: Financial Sector Development in the Pacific Rim, pages 95-111, National Bureau of Economic Research, Inc.
    2. 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.

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    More about this item

    Keywords

    real estate bubble; lender optimism; disaster myopia; Asian financial crisis;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • L85 - Industrial Organization - - Industry Studies: Services - - - Real Estate Services
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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