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Underpriced Default Spread Exacerbates Market Crashes

34 Pages Posted: 23 Jun 2006  

Winston T.H. Koh

Singapore Management University - School of Social Sciences

Roberto S. Mariano

Singapore Management University

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Sock Yong Phang

Singapore Management University - School of Economics

Augustine H.H. Tan

Singapore Management University - School of Social Sciences

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Finance Department

Date Written: October 9, 2006

Abstract

In this paper, we develop a specific observable symptom of a banking system that underprices the default spread in non-recourse asset-backed lending. Using three different data sets for 18 countries and property types, we find that, following a negative demand shock, the "underpricing" economies experience far deeper asset market crashes than economies in which the put option is correctly priced. Furthermore, only one of the countries in our sample continues to exhibit the underpricing symptom following a market crash. This indicates that market crashes have a cleansing effect and eliminate underpricing at least for a period of time. This makes investing in such markets safer following a negative demand shock.

Keywords: real estate bubble, lender optimism, disaster myopia, Asian financial crisis

Suggested Citation

Koh, Winston T.H. and Mariano, Roberto S. and Pavlov, Andrey D. and Phang, Sock Yong and Tan, Augustine H.H. and Wachter, Susan M., Underpriced Default Spread Exacerbates Market Crashes (October 9, 2006). U of Penn, Inst for Law & Econ Research Paper No. 06-13. Available at SSRN: https://ssrn.com/abstract=910964 or http://dx.doi.org/10.2139/ssrn.910964

Winston T.H. Koh

Singapore Management University - School of Social Sciences ( email )

469 Bukit Timah Road
Federal Building #02-08
Singapore, 259756
Singapore
+65 6822 0853 (Phone)
+65 6822 0833 (Fax)

Roberto S. Mariano

Singapore Management University ( email )

50 Stamford Rd.
Singapore 912409, 178899
Singapore

Andrey D. Pavlov (Contact Author)

Simon Fraser University (SFU) - Finance Area ( email )

Burnaby, British Columbia V5A 1S6
Canada
604 291 5835 (Phone)
604 291 4920 (Fax)

Sock Yong Phang

Singapore Management University - School of Economics ( email )

90 Stamford Road
178903
Singapore

Augustine H.H. Tan

Singapore Management University - School of Social Sciences ( email )

Tanglin P.O. Box 257
Singapore 912409
Singapore
+65 6822 0379 (Phone)
+65 6822 0101 (Fax)

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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