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Cross-Market and Cross-Firm Effects in Implied Default Probabilities and Recovery Values

38 Pages Posted: 19 Mar 2011  

Jennifer S. Conrad

University of North Carolina Kenan-Flagler Business School

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business

Allaudeen Hameed

National University of Singapore (NUS) - Department of Finance

Date Written: March 15, 2011

Abstract

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.

Keywords: CDS, options,default probabilities, recovery

JEL Classification: C13, C14, G12, G13, G20

Suggested Citation

Conrad, Jennifer S. and Dittmar, Robert F. and Hameed, Allaudeen, Cross-Market and Cross-Firm Effects in Implied Default Probabilities and Recovery Values (March 15, 2011). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1786977 or http://dx.doi.org/10.2139/ssrn.1786977

Jennifer S. Conrad (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Allaudeen Hameed

National University of Singapore (NUS) - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore

HOME PAGE: http://www.bschool.nus.edu.sg/staff_profile/cv.asp?ID=3

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