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Implied Market Loss Given Default: structural-model approach

This paper focuses on the key credit risk parameter–Loss Given Default (LGD). We describe its general properties and determinants with respect to seniority of debt, characteristics of debtors or macroeconomic conditions. Further, we illustrate how the LGD can be extracted from market observable information with help of the adjusted Mertonian structural approach. We present a derivation of the formula for expected LGD and show its sensitivity analysis with respect to other structural parameters of the company. Finally, we estimate the 5-year expected LGDs for companies listed on Prague Stock Exchange and find out, that the average LGD for this analyzed sample is around 20%. To the author’s best knowledge, those are the first implied market estimates of LGD in the Czech Republic.

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Paper provided by Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies in its series Working Papers IES with number 2008/26.

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Length: 32pages
Date of creation: Oct 2008
Date of revision: Oct 2008
Handle: RePEc:fau:wpaper:wp2008_26
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  1. Sarig, Oded & Warga, Arthur, 1989. "Bond Price Data and Bond Market Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 367-378, September.
  2. Gregor Andrade & Steven N. Kaplan, 1997. "How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed," NBER Working Papers 6145, National Bureau of Economic Research, Inc.
  3. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
  4. Delianedis, Gordon & Geske, Robert, 2001. "The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors," University of California at Los Angeles, Anderson Graduate School of Management qt32x284q3, Anderson Graduate School of Management, UCLA.
  5. Stephanou, Constantinos & Mendoza, Juan Carlos, 2005. "Credit risk measurement under Basel II : an overview and implementation issues for developing countries," Policy Research Working Paper Series 3556, The World Bank.
  6. Hull, John & White, Alan, 1995. "The impact of default risk on the prices of options and other derivative securities," Journal of Banking & Finance, Elsevier, vol. 19(2), pages 299-322, May.
  7. 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.
  8. Franks, Julian R & Torous, Walter N, 1989. " An Empirical Investigation of U.S. Firms in Reorganization," Journal of Finance, American Finance Association, vol. 44(3), pages 747-69, July.
  9. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  10. French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, vol. 17(1), pages 5-26, September.
  11. Francis A. Longstaff, 2000. "Arbitrage and the Expectations Hypothesis," Journal of Finance, American Finance Association, vol. 55(2), pages 989-994, 04.
  12. French, Kenneth R., 1980. "Stock returns and the weekend effect," Journal of Financial Economics, Elsevier, vol. 8(1), pages 55-69, March.
  13. Yakov Amihud & Kenneth Garbade & Marcel Kahan, 2000. "An Institutional Innovation To Reduce The Agency Costs Of Public Corporate Bonds," Journal of Applied Corporate Finance, Morgan Stanley, vol. 13(1), pages 114-121.
  14. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 59-117, January.
  15. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 541-552, November.
  16. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  17. Lawrence Fisher, 1959. "Determinants of Risk Premiums on Corporate Bonds," Journal of Political Economy, University of Chicago Press, vol. 67, pages 217.
  18. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
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