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Underpriced Default Spread Exacerbates Market Crashes

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Author Info

  • 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.

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File URL: https://mercury.smu.edu.sg/rsrchpubupload/6692/underprice.pdf
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Bibliographic Info

Paper provided by Singapore Management University, School of Economics in its series Working Papers with number 12-2006.

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Length: 32 pages
Date of creation: Mar 2006
Date of revision:
Publication status: Published in SMU Economics and Statistics Working Paper Series
Handle: RePEc:siu:wpaper:12-2006

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

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  1. Franklin Allen, 2001. "Presidential Address: Do Financial Institutions Matter?," Journal of Finance, American Finance Association, vol. 56(4), pages 1165-1175, 08.
  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, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  4. 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.
  5. 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.
  6. John Krainer & Chishen Wei, 2004. "House prices and fundamental value," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue oct1.
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Cited by:
  1. Roberto S. Mariano, 2009. "Misaligned Incentives and Mortgage Lending in Asia," Working Papers 07-2009, Singapore Management University, School of Economics.
  2. Richard K. Green & Roberto S. Mariano & Andrey D. Pavlov & Susan M. Wachter, 2007. "Misaligned Incentives and Mortgage Lending in Asia," Working Paper 9099, USC Lusk Center for Real Estate.
  3. 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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