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Pricing the Risks of Default

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  • Dilip Madan
  • Haluk Unal

Abstract

This paper characterizes the risk neutral jump process of default in terms of two entities, i) an instantaneous arrival rate of default and ii) a conditional density of the magnitude of the proportionate reduction in the value of creditors claims. The authors propose models for default arrival and magnitude risks as functions of evolving economic information. These two default components are then explicitly priced in the futures market with the spot price of risky debt being derived as a consequence. The resulting models for default arrival and magnitude risks are estimated on monthly data for rates on certificates of deposit offered by institutions in the Savings and Loan Industry. The data period is January 1987 to December 1991. The default arrival rate is modeled as responsive to abnormal equity returns, while default magnitude risk is modeled to be sensitive to the level of core deposits and the yield on low grade bonds. The authors' empirical results for the arrival and magnitude risk models provide strong support for the hypothesis that uninsured depositors place market discipline on the depository institutions by demanding compensation for both forms of the firm's default risks.

Suggested Citation

  • Dilip Madan & Haluk Unal, 1996. "Pricing the Risks of Default," Center for Financial Institutions Working Papers 94-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
    • Handle: RePEc:wop:pennin:94-16
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    Cited by:

    1. Gurdip Bakshi & Dilip B. Madan & Frank X. Zhang, 2001. "Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates," Finance and Economics Discussion Series 2001-37, Board of Governors of the Federal Reserve System (U.S.).
    2. Sulin Pang & Jinwang Xiao & Shuqing Li, 2015. "Pricing method and applications for the farmer's joint liability based on intensity model and Monte Carlo simulation," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(01), pages 1-21.
    3. Darrel Duffie & Damir Filipović & Walter Schachermayer, 2002. "Affine Processes and Application in Finance," NBER Technical Working Papers 0281, National Bureau of Economic Research, Inc.
    4. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
    5. Das, Sanjiv Ranjan & Acharya, Viral & Sundaram, Rangarajan K, 2002. "Pricing Credit Derivatives with Rating Transitions," CEPR Discussion Papers 3329, C.E.P.R. Discussion Papers.
    6. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," The Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    7. Gregory R. Duffee, "undated". "Treasury Yields and Corporate Bond Yield Spreads: An Empirical Analysis," Finance and Economics Discussion Series 1996-20, Board of Governors of the Federal Reserve System (U.S.), revised 10 Dec 2019.
    8. Viral V. Acharya & Jennifer N. Carpenter, 2002. "Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy," The Review of Financial Studies, Society for Financial Studies, vol. 15(5), pages 1355-1383.
    9. Vink, Dennis, 2007. "An Empirical Analysis of Asset-Backed Securitization," MPRA Paper 10382, University Library of Munich, Germany, revised 25 Aug 2008.
    10. Acharya, Viral & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.
    11. Li Chen & H. Vincent Poor, 2003. "Markovian Quadratic Term Structure Models For Risk-free And Defaultable Rates," Finance 0303008, University Library of Munich, Germany.
    12. Gurdip Bakshi & Dilip B. Madan & Frank X. Zhang, 2001. "Investigating the sources of default risk: lessons from empirically evaluating credit risk models," Finance and Economics Discussion Series 2001-15, Board of Governors of the Federal Reserve System (U.S.).
    13. Li Chen & H. Vincent Poor, 2002. "A General Characterization of Quadratic Term Structure Models," Finance 0211008, University Library of Munich, Germany.
    14. Alexander David, 1998. "Pricing the strategic value of poison put bonds," Finance and Economics Discussion Series 1998-06, Board of Governors of the Federal Reserve System (U.S.).
    15. Chen, Cho-Jieh & Panjer, Harry, 2003. "Unifying discrete structural models and reduced-form models in credit risk using a jump-diffusion process," Insurance: Mathematics and Economics, Elsevier, vol. 33(2), pages 357-380, October.
    16. Li Chen & H. Vincent Poor, 2003. "Credit Risk Modeling and the Term Structure of Credit Spreads," Finance 0312009, University Library of Munich, Germany.
    17. Gann, Philipp, 2008. "Der Internal Capital Adequacy Assessment Process als regulatorischer Treiber eines aktiven Kreditportfoliomanagements," Discussion Papers in Business Administration 4831, University of Munich, Munich School of Management.
    18. Maclachlan, Iain C, 2007. "An empirical study of corporate bond pricing with unobserved capital structure dynamics," MPRA Paper 28416, University Library of Munich, Germany.
    19. Steven R. Grenadier & Brian J. Hall, 1995. "Risk-Based Capital Standards and the Riskiness of Bank Portfolios: Credit and Factor Risks," NBER Working Papers 5178, National Bureau of Economic Research, Inc.
    20. Olivier Le Courtois & François Quittard-Pinon, 2006. "Risk-neutral and actual default probabilities with an endogenous bankruptcy jump-diffusion model," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 13(1), pages 11-39, March.

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