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Implied probabilities of default from Colombian money market spreads: The Merton Model under equity market informational constraints

Listed author(s):
  • Carlos León


Informational constraints may turn the Merton Model for corporate credit risk impractical. Applying this framework to the Colombian financial sector is limited to four stock-market-listed firms; more than a hundred banking and non-banking firms are not listed. Within the same framework, firms' debt spread over the risk-free rate may be considered as the market value of the sold put option that makes risky debt trade below default-risk-free debt. In this sense, under some supplementary but reasonable assumptions, this paper uses money market spreads implicit in sell/buy backs to infer default probabilities for local financial firms. Results comprise a richer set of (38) banking and non-banking firms. As expected, default probabilities are non-negligible, where the ratio of default-probability-to-leverage is lower for firms with access to lender-of-last-resort facilities. The approach is valuable since it allows for inferring forward-looking default probabilities in the absence of stock prices. Yet, two issues may limit the validity of results to serial and cross-section analysis: overvaluation of default probabilities due to (i) spreads containing non-credit risk factors, and (ii) systematic undervaluation of the firm's value. However, cross-section assessments of default probabilities within a wider range of firms are vital for financial authorities' decision making, and represent a major improvement in the implementation of the Merton Model in absence of equity market data.

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Paper provided by BANCO DE LA REPÚBLICA in its series BORRADORES DE ECONOMIA with number 010075.

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Length: 34
Date of creation: 30 Oct 2012
Handle: RePEc:col:000094:010075
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  1. Carlos León Rincón & Alejandro Reveiz, 2011. "Montecarlo simulation of long-term dependent processes: a primer," BORRADORES DE ECONOMIA 008277, BANCO DE LA REPÚBLICA.
  2. Carlos León & Andrés Murcia, 2012. "Systemic Importance Index for financial institutions: A Principal Component Analysis approach," Borradores de Economia 741, Banco de la Republica de Colombia.
  3. Carlos León & Karen Leiton & Alejandro Reveiz, 2012. "Investment Horizon Dependent CAPM: Adjusting beta for long-term dependence," BORRADORES DE ECONOMIA 009909, BANCO DE LA REPÚBLICA.
  4. Pamela A. Cardozo & Carlos A. Huertas C. & Julián A. Parra P. & Lina V. Patiño Echeverri, 2011. "Mercado interbancario colombiano y manejo de liquidez del Banco de la República," BORRADORES DE ECONOMIA 009017, BANCO DE LA REPÚBLICA.
  5. Jhonatan Pérez Villalobos & Juan Carlos Mendoza Gutiérrez de Piñeres, 2010. "Efecto día en el mercado accionario Colombiano: una aproximación no paramétrica," Borradores de Economia 585, Banco de la Republica de Colombia.
  6. Kenneth R. French & Martin N. Baily & John Y. Campbell & John H. Cochrane & Douglas W. Diamond & Darrell Duffie & Anil K Kashyap & Frederic S. Mishkin & Raghuram G. Rajan & David S. Scharfstein & Robe, 2010. "The Squam Lake Report: Fixing the Financial System," Economics Books, Princeton University Press, edition 1, number 9261.
  7. Dumitru MATIS & Carmen Giorgiana BONACI, 2008. "Fair Value Accounting for Financial Instruments – Conceptual Approach and Implications," Timisoara Journal of Economics, West University of Timisoara, Romania, Faculty of Economics and Business Administration, vol. 1(2), pages 191-206.
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