Price of Risk: Recent Evidence From Large Financials

IMF Working Papers, August 1, 2010

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Probability of default (PD) measures have been widely used in estimating potential losses of, and contagion among, large financial institutions.
In a period of financial stress, existing methods to compute PDs and generate loss estimates may vary significantly.
The paper discusses three issues that should be taken into account in using PD-based methodologies for loss or contagion analyses:
- (i) the use of - risk-neutral probabilities - vs. -real-world probabilities;
- (ii) the divergence between movements in credit and equity markets during periods of financial stress; and
- (iii) the assumption of stochastic vs. fixed recovery for financial institutions’ assets.
All three elements have nontrivial implications for providing an accurate estimate of default probabilities and associated losses as inputs for setting policies related to large banks in distress.

Use of risk-neutral probabilities vs. real-world probabilities:
- The distinction between risk-neutral probabilities and real-world probabilities is emphasized as a central issue when deriving PDs for loss and contagion analysis.
Divergence between credit and equity market movements:
- Movements in credit and equity markets can diverge during periods of financial stress, affecting PD estimates that rely on either market signal.
Stochastic vs. fixed recovery assumptions:
- Assuming stochastic recovery rather than fixed recovery for financial institutions’ assets materially affects default probability estimates and associated loss projections.
Overall implication:
- All three elements—probability measure choice, market signal divergence, and recovery assumption—have nontrivial implications for accurate estimation of default probabilities and losses used in policy design for large banks in distress.

When using PD-based methodologies for policy or supervisory purposes, explicitly consider:
- Which probability measure is being used (risk-neutral vs. real-world).
- Potential divergence between credit-market signals (e.g., CDS spread) and equity-market signals (e.g., distance-to-distress, equity market volatility) especially in stress periods.
- Whether recovery assumptions are treated as stochastic or fixed, and the sensitivity of loss estimates to that choice.

Subject areas: Banking, Credit, Credit default swap, Financial crises, Financial markets, Money, Securities markets, Stock markets
Keywords cited: CDS spread, CDS SpreadEDF, CDS SpreadEquity market signal, cheapest-to-deliver bonds, Credit, Credit default swap, distance-to-distress, equity market volatility, Global, JPoD, LCFIs, Price of risk, real-world probabilities, risk neutrality assumption, risk-neutral probabilities, sc, Securities markets, Stock markets, WP