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Separating the Components of Default Risk: A Derivative-Based Approach

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  • Anh Le

    (UNC Kenan-Flagler Business School, McColl Building, CB 3490, Chapel Hill, NC 27599, United States)

Abstract

In this paper, I propose a general pricing framework that allows therisk neutraldynamics of loss given default(Lℚ)and default probabilities (λℚ) to be separately and sequentially discovered. The key is to exploit the differentials inLℚexhibited by different securities on the same underlying firm. By using equity and option data, I show that one can efficiently extract pure measures of λℚthat are not contaminated by recovery information. Equipped with this knowledge of pure default dynamics, prices of any defaultable security on the same firm with non-zero recovery can be inverted to compute the associatedLℚcorresponding to that particular security. Using data on credit default swap premiums, I show that, cross-sectionally, λℚandLℚare positively correlated. In particular, this positive correlation is strongly driven by firms' characteristics, including leverage, volatility, profitability andq-ratio. For example, 1% increase in leverage leads to 0.14% increase in λℚand 0.60% increase inLℚ.

Suggested Citation

  • Anh Le, 2015. "Separating the Components of Default Risk: A Derivative-Based Approach," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 5(01), pages 1-48.
    • Handle: RePEc:wsi:qjfxxx:v:05:y:2015:i:01:n:s2010139215500056
    DOI: 10.1142/S2010139215500056
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    References listed on IDEAS

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    1. Campi, L. & Polbennikov, S.Y. & Sbuelz, A., 2005. "Assessing Credit with Equity : A CEV Model with Jump to Default," Other publications TiSEM 21b78fcf-8401-4e4d-8224-7, Tilburg University, School of Economics and Management.
    2. Marcin Jaskowski & Michael McAleer, 2012. "Estimating Implied Recovery Rates from the Term Structure of CDS Spreads," Documentos de Trabajo del ICAE 2012-28, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
    3. Luciano Campi & Simon Polbennikov & Sbuelz, 2005. "Assessing Credit with Equity: A CEV Model with Jump to Default," Working Papers 24/2005, University of Verona, Department of Economics.
    4. Campi, L. & Polbennikov, S.Y. & Sbuelz, A., 2005. "Assessing Credit with Equity : A CEV Model with Jump to Default," Discussion Paper 2005-27, Tilburg University, Center for Economic Research.
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    Cited by:

    1. Xin‐Jiang He & Wenting Chen, 2021. "A semianalytical formula for European options under a hybrid Heston–Cox–Ingersoll–Ross model with regime switching," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(1), pages 343-352, January.
    2. Sha Lin & Xin-Jiang He, 2022. "Analytically Pricing European Options under a New Two-Factor Heston Model with Regime Switching," Computational Economics, Springer;Society for Computational Economics, vol. 59(3), pages 1069-1085, March.
    3. Jorge Cruz Lopez & Alfredo Ibanez, 2020. "European Puts, Credit Protection, and Endogenous Default," University of Western Ontario, Departmental Research Report Series 20205, University of Western Ontario, Department of Economics.
    4. Sha Lin & Xin‐Jiang He, 2024. "Closed‐Form Formulae for Variance and Volatility Swaps Under Stochastic Volatility With Stochastic Liquidity Risks," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(8), pages 1447-1461, August.
    5. Murphy, Austin & Headley, Adrian, 2022. "An empirical evaluation of alternative fundamental models of credit spreads," International Review of Financial Analysis, Elsevier, vol. 81(C).
    6. Jansen, Jeroen & Das, Sanjiv R. & Fabozzi, Frank J., 2018. "Local volatility and the recovery rate of credit default swaps," Journal of Economic Dynamics and Control, Elsevier, vol. 92(C), pages 1-29.
    7. Jean‐François Bégin & Mathieu Boudreault & Mathieu Thériault, 2024. "Leveraging prices from credit and equity option markets for portfolio risk management," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(1), pages 122-147, January.

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