Pricing the Risks of Default
Posted: 5 May 1995
Date Written: October 1996
This paper models default risk as composed of arrival and magnitude risks. In our model the two default components are explicitly priced as if they were traded in the futures market and the spot price of risky debt is derived as a consequence. We develop estimation strategies to evaluate the magnitude risks which are then employed to construct implicit prices of pure arrival risk contingent securities. The latter prices are used to estimate the structure of arrival risks. The models are estimated on monthly data for rates on certificates of deposit offered by institutions in the Savings and Loan Industry, during the 1987-1991 period. Empirical results support market expectations of lower likelihoods of default after 1989.This paper was presented at the Wharton Financial Institutions Center's conference on Risk Management in Banking, October 13-15, 1996.
JEL Classification: G13, G21, G12
Suggested Citation: Suggested Citation