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

See all articles by Robert A. Jarrow

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

Tibor Janosi

Cornell University - Department of Computer Science; Cornell University - Samuel Curtis Johnson Graduate School of Management

Yildiray Yildirim

Zicklin School of Business, Baruch College - The City University of New York

Date Written: November 12, 2012

Abstract

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

Jarrow, Robert A. and Janosi, Tibor and Yildirim, Yildiray, Estimating Default Probabilities Implicit in Equity Prices (November 12, 2012). Journal of Investment Management, Vol. 1, No 1, First Quarter 2003. Available at SSRN: https://ssrn.com/abstract=495109

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

Tibor Janosi (Contact Author)

Cornell University - Department of Computer Science ( email )

4130 Upson Hall
Ithaca, NY 14853
United States

Cornell University - Samuel Curtis Johnson Graduate School of Management

Ithaca, NY 14853
United States

Yildiray Yildirim

Zicklin School of Business, Baruch College - The City University of New York ( email )

55 Lexington Ave., Box B13-260
New York, NY 10010
United States

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