Cross-Market and Cross-Firm Effects in Implied Default Probabilities and Recovery Values
Jennifer S. Conrad
University of North Carolina Kenan-Flagler Business School
Robert F. Dittmar
University of Michigan, Stephen M. Ross School of Business
National University of Singapore (NUS) - Department of Finance
March 15, 2011
AFA 2012 Chicago Meetings Paper
We examine the relation between levels of, and changes in, estimates of default probabilities taken from the CDS market and the equity options market for non-financial and financial firms, before and during the credit crisis. We find a strong relation between estimates of default probabilities across these two markets, although the relationship is weaker prior to the credit crisis. When we use equity options' default probabilities to estimate time-varying recovery rates from CDS spreads, we find strong evidence that recovery rates vary through time, and that they are positively related to predictors of real economic activity and inversely related to measures of counterparty risk throughout the sample period. In addition, during the crisis period, default probabilities are also positively related to measures of market volatility. This result is consistent with deterioration in market liquidity, associated with increases in volatility, leading to a decline in solvency. Finally, we examine the time-series relation between changes in implied default probabilities and recovery rates and find two intriguing results. First, we find evidence that an increase in the default probability of financial firms is associated with an increase in the default probability of non-financial firms, although the reverse is not true. Second, we find evidence that an increase in the implied default probability of financial firms leads to a decrease in recovery rates of financial firms; this result is consistent with fire-sale effects. Overall, there is evidence that a deterioration in the prospects of financial firms has knock-on effects across the financial sector, as well as on the real economy.
Number of Pages in PDF File: 38
Keywords: CDS, options,default probabilities, recovery
JEL Classification: C13, C14, G12, G13, G20
Date posted: March 19, 2011
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