Probabilities of Default and the Market Price of Risk in a Distressed Economy

Author/Editor:

Miguel A. Segoviano ; Raphael A Espinoza

Publication Date:

April 1, 2011

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

We propose an original method to estimate the market price of risk under stress, which is needed to correct for risk aversion the CDS-implied probabilities of distress. The method is based, for simplicity, on a one-factor asset pricing model. The market price of risk under stress (the expectation of the market price of risk, conditional on it exceeding a certain threshold) is computed from the price of risk (which is the variance of the market price of risk) and the discount factor (which is the inverse of the expected market price of risk). The threshold is endogenously determined so that the probability of the price of risk exceeding it is also the probability of distress of the asset. The price of risk can be estimated via different methods, for instance derived from the VIX or from the factors in a Fama-MacBeth regression.

Series:

Working Paper No. 2011/075

Subject:

Asset prices Banking Credit default swap Factor models Market risk

English

Publication Date:

April 1, 2011

ISBN/ISSN:

9781455227044/1018-5941

Stock No:

WPIEA2011075

Pages:

14

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