Estimating Default Probabilities Implicit in Equity Prices
Journal of Investment Management, Vol. 1, No 1, First Quarter 2003
38 Pages Posted: 2 Apr 2004 Last revised: 12 Nov 2012
Date Written: November 12, 2012
This paper uses a reduced form credit risk model to estimate default probabilities implicit in equity prices. For a cross-section of firms, a time-series regression of monthly equity returns is estimated. We show that it is feasible to infer the firm's probability of default implicit in equity returns. However, the existence of price bubbles and the difficulty in modeling equity price risk premium confound the estimation of these default probabilities, generating potentially biased estimates with large standard errors. Comparing these default intensities with those obtained from historical data or implicitly from debt prices confirms this result.
Keywords: Credit risk
JEL Classification: G00
Suggested Citation: Suggested Citation