Default Risk Research Papers - Academia.edu (original) (raw)

We characterize the exchange of financial claims from risky swaps. These transfers are among three groups: shareholders, debtholders, and the swap counterparty. From this analysis we derive equilibrium swap rates and relate them to debt market spreads. We then show that equilibrium swaps in perfect markets transfer wealth from shareholders to debtholders. In a simplified case, we obtain closed-form solutions for the value of the default risk in the swap. For interest-rate swaps, we obtain numerical solutions for the equilibrium swap rate, including default risk. We compare these with equilibrium debt market default risk spreads.

- by
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- Finance, Default Risk, Interest Rate, Numerical Solution

Risk capital is the contribution of an exposure to the default risk of a financial institution. We investigate its relationship with required shareholder returns, showing that the use of return on risk capital (RAROC) as a risk-adjusted performance measure is inconsistent with the standard theory of financial valuation and that using this one measure to represent at the same time both contribution to default risk and required shareholder returns can lead to substantial loss of shareholder value. We propose an alternative performance measure distinguishing these two aspects of risk and applicable to the efficient allocation of risk capital.[99 words] Journal of Economic Literature number: G21

- by Alistair Milne
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- Default Risk, Performance Measure
- by Wim Moesen
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- Profitability, Default Risk, Financial Market, Empirical evidence

We model and examine the financial aspects of the land development process incorporating the industry practice of preselling lots to builders through the use of option contracts as a risk management technique. Using contingent claims valuation, we are able to determine endogenously the land value, presale option value, credits spreads and the effects of presales on debt pricing and equity expected returns. We show that using presales options effectively shift market risk from the land developer to the builder. Results from the model are consistent with the high rates of return on equity observed in empirical surveys; they also suggest that developers may be justified in pursuing projects with substantially lower expected returns to equity when a large number of lots can be presold. Additionally, we show that presales reduce default risk dramatically for leveraged projects and can support a considerable reduction in the cost of construction financing. Large debt risk premiums are justified for highly levered projects, which helps explain the use of mezzanine financing in the land development industry to reduce expected default costs.

- by Steven Ott
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- Risk Management, Applied Economics, Land Development, Rate of return

There have been major changes in the way European insurance markets are regulated, and there is still considerable debate about what the form and scope of regulation should be. This article examines the arguments for solvency regulation when consumers are fully informed of the insurer's insolvency risk. It is shown firms always provide enough capital to ensure solvency, unless there are restrictions on the composition of their asset portfolios. The conclusion holds even when competition means that only normal profits can be earned. This suggests that the role of regulation in insurance markets should be confined to providing consumers with information about the default risk of insurers.

- by Hugh Gravelle and +1
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- Profitability, Default Risk, Insurance Market

Several scholars of financial economics observed that during the 1980s, market interest rates declined continuously with little or no impact on credit card rates. Recently, , recorded sigmficant changes in the credit card market intffcating an increased level of competition. This study represents an attempt to determine the sensitivity of credit card rates to the costs of funds in the U.$. economy. The evidence from the Johansen Cointegration test confirms that credit card rates and cost of funds possess a long-run equilibrium relationship with one another. Furthermore, the results of the error correction models are indicative of a sluggish rate at which credit card interest rates adjust to the costs of funds. Between 1982 and 1994, credit card rates adjust to changes in the cost of funds at about 15 percent per quarter. These results represent anecdotal evidence for the validity of adverse selection, search and switch costs explanations that have been discussed in the financial contracting literature.

- by Felix Ayadi
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- Adverse Selection, Credit Card Default Problems, Default Risk, Search Costs

We discuss extensions of reduced-form and structural models for pricing credit risky securities to portfolio simulation and valuation. Stochasticity in interest rates and credit spreads is captured via reduced-form models and is incorporated with a default and migration model based on the structural credit risk modelling approach. Calculated prices are consistent with observed prices and the term structure of default-free and defaultable interest rates. Three applications are discussed: (i) study of the inter-temporal price sensitivity of credit bonds and the sensitivity of future portfolio valuation with respect to changes in interest rates, default probabilities, recovery rates and rating migration, (ii) study of the structure of credit risk by investigating the impact of disparate risk factors on portfolio risk, and (iii) tracking of corporate bond indices via simulation and optimisation models. In particular, we study the effect of uncertainty in credit spreads and interest rates on the overall risk of a credit portfolio, a topic that has been recently discussed by Kiesel et al. [The structure of credit risk: spread volatility and ratings transitions. Technical report, Bank of England, ISSN 1268ISSN -5562, 2001], but has been otherwise mostly neglected. We find that spread risk and interest rate risk are important factors that do not diversify away in a large portfolio context, especially when high-quality instruments are considered.

- by Stavros A. Zenios
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- Production Management, Multidisciplinary, Credit Risk, Default Risk

India’s leading infrastructure development and financial services company - Infrastructure Leasing & Financial Services (IL&FS) and its subsidiary companies failed to repay multiple debt obligations and thereby started to default in mid-2018. This caused panic in the Indian debt market creating a cascading effect on other financial services, particularly in the NBFC sector. Government of India and the monetary regulator – the Reserve Bank of India (RBI) quickly stepped in to rescue the company. Rejecting a blanket bailout solution, but considering the “too big to fail” size of the company, they took timely action barely avoiding a total financial collapse. This meant that India avoided a ‘Lehman Brothers moment’. This paper explores reasons leading to the crisis, steps taken by Government and regulators to rescue, consequences of the default and lessons learnt from the experience. While Indian experience in large-scale financial defaults is limited, this paper takes the opportunity to understand the problem and post-crisis handling. Learnings from this study can help strengthen regulatory provisions so that these do not recur, minimize the trouble from spreading to other financial segments of the economy and possibly protect the vulnerable company stakeholders such as creditors, investors etc.

- by Vijaya Kittu Manda and +1
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- Financial Risk Management, Financial Crisis, Default Risk, Liquidity
- by Tony Bellotti
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- Econometrics, Statistics, Logistic Regression, Panel Data

The aim of this paper is to study the impact of structure of dependency on the pricing of multi-name credit derivatives such as collateralised debt obligations (CDO). The correlation between names defaulting has an effect on the value of the basket credit derivatives. We present a copula based simulation procedure for pricing CDO under different structure of dependency and assessing the influence of different price drivers (correlation, hazard rates and recovery rates) on modelling portfolio losses. Gaussian copulas and Monte Carlo simulation are widely used to measure the default risk in basket credit derivatives. Many studies have shown that many distributions have fatter tails than those captured by the normal distribution. We use distributions with fat tails such as the t-student distribution. The paper has several practical implications that are of value for financial hedgers and engineers, financial regulators, central banks, and financial risk managers.

- by Fathi Abid
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- Monte Carlo Simulation, Financial Risk Management, Regulation, Risk Management

This thesis lies at the intersection of mathematics, finance and numerical methods. The financial question of how to model credit risk, specifically corporate bond defaults, and how to model correlations between defaults, motivates our study of the mathematics behind a specific kind of credit risk models called hazard rate models. We consider corporate bond defaults as random events and apply a probabilistic framework to pricing defaultable corporate bonds and to analyzing the case of multi-entity defaults and default correlations. Using the R programming language, we simulate different algorithms and discretization schemes of stochastic processes, checking our theoretical results with simulation results and numerically solving stochastic differential equations where we do not know the closed-form solutions. This motivates us to study and test performance of different simulation methods of stochastic differential equations. In the end, we give a short summary of the two other types of credit risk models as comparisons to think critically of hazard rate models so as to better answer the financial question of how to model credit risk.

- by Xinyu Liu
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- Finance, Stochastic Process, Financial Risk Management, Probability

Among the most controversial issues in the literature, and empirical studies that have addressed the subject of bankruptcy prediction, there is certainly the understanding of what kind of indicators is most predictive in the report on time, and especially with fewer errors thorough a corporate crisis. In this regard, the present work contributes to the already vast literature that analyzes the determinants of the probability of firm default, with particular attention to the quantities contained in the accounting ratios. With the support of 9,390 Italian SMEs will occur the specific contribution of each ratio within each rating category considering, therefore, the predictive value of each explanatory variable. This survey's results can even prove the predictive ability of capital structure and debt coverage compared to the minor validity of some indicators of turnover, profitability, and cash conversion cycle.

- by Marco Muscettola
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- Credit Rating, SME finance, Default Risk, Model Accuracy
- by Kasper Roszbach
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- Impulse response, Default Risk, Empirical Study, Financial Stability

We propose an evaluation method for financial assets subject to default risk, when investors face imperfect information about the state variable triggering the default. The model we propose generalizes the one by in the following way: (i) it incorporates informational noise in continuous time, (ii) it respects the (H) hypothesis, (iii) it precludes arbitrage from insiders. The model is sufficiently general to encompass a large class of structural models. In this setting we show that the default time is totally inaccessible in the market's filtration and derive the martingale hazard process. Finally, we provide pricing formulas for default-sensitive claims and illustrate with particular examples the shapes of the credit spreads and the conditional default probabilities. An important feature of the conditional default probabilities is they are non Markovian. This might shed some light on observed phenomena such as the "rating momentum".

- by Hélyette Geman and +1
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- Applied Mathematics, Statistics, Default Risk, Credit Spread

The link between credit risk and the current financial crisis accentuates the importance of measuring and predicting extreme credit risk. Conditional Value at Risk (CVaR) has become an increasingly popular method for measuring extreme market risk. We apply these CVaR techniques to the measurement of credit risk and compare the probability of default among Australian sectors prior to and during the financial crisis. An in depth understanding of sectoral risk is vital to Banks to ensure that there is not an overconcentration of credit risk in any sector. This paper demonstrates how CVaR methodology can be applied in different economic circumstances and provides Australian Banks with important insights into extreme sectoral credit risk leading up to and during the financial crisis.

- by David E D M U N D Allen
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- Real Estate, Tobacco, Financial Crisis, Credit Risk

This paper develops a dynamic stochastic general equilibrium model with interactions between an heterogeneous banking sector and other private agents. We introduce endogenous default probabilities for both firms and banks, and allow for bank regulation and liquidity injection into the interbank market. Our aim is to understand the importance of supervisory and monetary authorities to restore financial stability. The model is calibrated against real data and used for simulations. We show that liquidity injections reduce financial instability but have ambiguous effects on output fluctuations. The model also confirms the partial equilibrium literature results on the procyclicality of Basel II.

- by Gregory de Walque
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- Economics, Money, DSGE, Default Risk

Loan-to-value ratio and debt service coverage ratios have long been viewed as the two most important quantitative measures of the default risk of commercial mortgages. Option-based models of default provide strong theoretic support for the importance of original loan-to-value ratio. The same theoretical predictions have found strong empirical support in residential single-family mortgage analyses. However, recent empirical studies of commercial mortgage default have raised questions about the role of loan-to-value ratio in assessing the riskiness of commercial mortgages. These studies generally either find no relationship or a puzzling negative relationship between loan-to-value ratio and default. This paper uses a very large database of commercial loan histories to thoroughly investigate this issue. It finds strong evidence that loan-to-value and debt service coverage ratios are endogenous to the underwriting process. Lenders react to other-unmeasured-risk factors with credit rationing and pricing. As a result, unusually low loan-to-value ratio loans appear to have above average risk in other dimensions and their default probabilities are equal to or higher than average. The results show that the pricing spread that lenders establish as part of the underwriting process serves as an excellent summary measure of the riskiness of the loan. A test of lendersÕ ability to appropriately price loan-to-value risk finds that, while there is some unpriced effect of 1051-1377/$ -see front matter Ó HOUSING ECONOMICS loan-to-value ratio after controlling for the lenderÕs pricing, introducing lender pricing into the model removes the otherwise puzzling negative loan-to-value and default relationship previously observed in the literature.

- by Risky Dsc
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- Housing Economics, Urban And Regional Planning, Applied Economics, Default Risk

This work deals with backward stochastic differential equation (BSDE) with random marked jumps, and their applications to default risk. We show that these BSDEs are linked with Brownian BSDEs through the decomposition of processes with respect to the progressive enlargement of filtrations. We prove that the equations have solutions if the associated Brownian BSDEs have solutions. We also provide a uniqueness theorem for BSDEs with jumps by giving a comparison theorem based on the comparison for Brownian BSDEs. We give in particular some results for quadratic BSDEs. As applications, we study the pricing and the hedging of a European option in a market with a single jump, and the utility maximization problem in an incomplete market with a finite number of jumps.

- by Thomas Lim
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- Statistics, Pure Mathematics, Default Risk, Utility Maximization

This paper compares lending policies of formal, informal and semiformal lenders with respect to household lending in Vietnam. The analysis suggests that the probability of using formal or semiformal credit increases if borrowers provide collateral, a guarantor and/or borrow for business-related activities. The probability of using informal credit increases for female borrowers. It also appears that the probability of using formal credit increases in household welfare up to a certain threshold, but at a decreasing rate. In addition, the paper discerns the determinants of probability of default across lender types. Default risk of formal credit appears to be strongly affected by formal loan contract terms, e.g., loan interest rate and form of loan repayment, whereas default risk on informal loans is significantly related to the presence of propinquity and other internal characteristics of the borrowing household. Overall, the study raises several important implications for the screening, monitoring and enforcement instruments that may be employed by different types of lenders.

- by Robert Lensink
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- Transition Economics, Risk, Vietnam, Applied Economics

This study investigates the valuation models for three types of catastrophe-linked instruments: catastrophe bonds, catastrophe equity puts, and catastrophe futures and options. First, it looks into the pricing of catastrophe bonds under stochastic interest rates and examines how reinsurers can apply catastrophe bonds to reduce the default risk. Second, it models and values the catastrophe equity puts that give the

- by Min-teh Yu
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- Risk Management, Default Risk, Indexation

W e examine, both theoretically and empirically, top-management compensation in the presence of agency conflicts when shareholders have delegated governance responsibilities to a self-interested Board of Directors (BOD). We develop a theoretical framework that explicitly incorporates the BOD as a strategic player, models the negotiation process between the CEO and the BOD in designing CEO compensation, and considers the impact of potential takeovers by large shareholders monitoring the CEO-BOD negotiations. In equilibrium, internal governance by the BOD and external takeover threats by a large shareholder act as substitutes in imposing managerial control, especially in constraining management's profligacy in awarding equity-based compensation to itself. The model emphasizes factors in the design of compensation contracts that are rarely considered in the literature, such as equity ownership of the largest outside shareholder and the firm's bankruptcy risk. It also provides new perspectives on factors that are often considered in the literature, such as firm size, firm performance, equity ownership of the BOD, and BOD structure. Our empirical tests lend considerable support for our theoretical predictions. Equity ownership of the largest external shareholder, that of the BOD, and the default risk, are strongly negatively related to the size of CEO equity compensation. Consistent with the theoretical model, these factors do not significantly influence the growth of fixed (or non-performance-related) compensation. We also find that the equity ownership of the BOD is more important in managerial compensation control than other BOD related variables, such as BOD size or the proportion of outside directors. (Corporate Governance and Board of Directors; Takeover Threats; Stock Options and CEO Compensation; Default Risk ) J 1 ∈ C J 1 denote the outcome in the negotiation game between J and M, where C J 1 = A J 1 n J 1 is the mutually agreed upon compensation, and represents the alternative event. When O J 1 , where U L J Next, let, C J 1 = A J 1 n J J 1 is (i) decreasing in L , (ii) decreasing in J if the default probability is not too large, (iii) increasing in , (iv) increasing in N , and (v) decreasing in the default probability Q. But the relation of n J 1 to Z (the "magnitude" of the growth-opportunity), , D, and M is ambiguous. Proposition 2. The relation of the equilibrium fixed salary A J 1 to the variables specified in Proposition 1 is generally ambiguous. However, the relation of A J 1 to these variables is opposite in sign to that of n J 1 if M borrows up to the debt capacity of the firm. 9 Proofs of these comparative statics are available from the authors.

- by Praveen Kumar
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- Corporate Governance, CEO compensation, Management Science, Firm Performance

Based on the and (BSM) contingent claims model, and KMV Corporation framework, we estimate the distance to default and the "risk neutral" default probabilities for a sample of 112 real estate companies over the period 1980 to 2001. Our empirical results classifies failed and non-failed companies into Type I error, cases that the BSM-type model fails to predict default when it did occur, and Type II error where BSM-type model predicts default when it did not occur. We find that none of the companies belong to the category of Type I error. Type II error is observed in 10 out of 112 companies. These results support the theoretical underpinnings of the BSMtype structural model in that the two driving forces of default are high leverage and high asset volatility.

- by Prodromos Vlamis
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- Real Estate, Political Economy, Applied Economics, Credit Risk

This paper analyses default risk of wage-indexed payment mortgage (WIPM) in Turkey in comparison with other standard mortgage contracts originated in high inflationary economies. Emlak Bank launched WIPM linked to Civil Service employeesÕ wage (CSW) index during high inflationary period of late 1990s. Concurrently, the government introduced a policy linking CSW index to semi-annual expected rate of inflation in an attempt to facilitate housing finance for the fastest growing sector of the population. We find that WIPM protects borrowers against risk of high payment shocks whereas nominal contracts such as ARM and DIM would have resulted in high mortgage defaults.

- by Işıl Erol
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- Default Risk
- by Darrell Duffie
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- Applied Mathematics, Survival Analysis, Credit Risk, Stochastic Volatility

To evaluate loan applicants, banks increasingly use credit scoring models. The objective of such models typically is to minimize default rates or the number of incorrectly classified loans. Thereby they fail to take into account that loans are multiperiod contracts for which reason it is important for banks not only to know if but also when a loan will default. In this paper a bivariate Tobit model with a variable censoring threshold and sample selection effects is estimated for (1) the decision to provide a loan or not and (2) the survival of granted loans. The model proves to be an effective tool to separate applicants with short survival times from those with long survivals. The bank's loan provision process is shown to be inefficient: loans are granted in a way that conflicts with both default risk minimization and survival time maximization. There is thus no trade-off between higher default risk and higher return in the lending policy.

- by Kasper Roszbach
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- Econometrics, Credit Scoring, Applied Economics, Default Risk

The purpose of this paper is introducing rigorous methods and formulas for bilateral counterparty risk credit valuation adjustments (CVA's) on interest-rate portfolios. In doing so, we summarize the general arbitrage-free valuation framework for counterparty risk adjustments in presence of bilateral default risk, as developed more in detail in , including the default of the investor. We illustrate the symmetry in the valuation and show that the adjustment involves a long position in a put option plus a short position in a call option, both with zero strike and written on the residual net present value of the contract at the relevant default times. We allow for correlation between the default times of the investor and counterparty, and for correlation of each with the underlying risk factor, namely interest rates. We also analyze the often neglected impact of credit spread volatility. We include Netting in our examples, although other agreements such as Margining and Collateral are left for future work.

- by Damiano Brigo
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- Computational Finance, Papers, Counterparty Risk, Default Risk

This work deals with backward stochastic differential equation (BSDE) with random marked jumps, and their applications to default risk. We show that these BSDEs are linked with Brownian BSDEs through the decomposition of processes with respect to the progressive enlargement of filtrations. We show that the equations have solutions if the associated Brownian BSDEs have solutions. We also provide a uniqueness theorem for BSDEs with jumps by giving a comparison theorem based on the comparison for Brownian BSDEs. We give in particular some results for quadratic BDSEs. As applications, we study the pricing and the hedging of a European option in a complete market with a single jump, and the utility maximization problem in an incomplete market with a finite number of jumps.

- by Thomas Lim
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- Statistics, Pure Mathematics, Default Risk, Utility Maximization

The selection of a given purchasing strategy is a central activity in risky environments. Single sourcing, a powerful approach in a stable environment, can amplify a firm's exposure to risk (e.g., supplier's default) in the presence of uncertainty. Multiple sourcing, however, presents higher costs due to the management of more than one supplier. A correct evaluation from a risk management perspective is needed. This paper proposes the Real Options approach for valuing the probabilistic benefits of multiple sourcing in managing the supplier default risk (to be compared with the related higher costs). A computational model, based on the Monte Carlo simulation, was developed. The results show the (probabilistic) advantages of adopting the multiple sourcing strategy in risky environments for a specific case. The proposed sensitivity analysis is aimed at identifying the impact of the most important transactional parameters on the differential benefits of the two sourcing strategies. Thus, the model and its managerial implications represent a valid support for the decision-making process in the presence of uncertainty.

- by Nicola Costantino
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- Marketing, Monte Carlo Simulation, Monte Carlo, Risk Management

The Internal Ratings Based (IRB) approach for capital determination is one of the cornerstones in the proposed revision of the Basel Committee rules for bank regulation. We evaluate the IRB approach using historical business loan portfolio data from a major Swedish bank for the period 1994 to 2000. First, we estimate a duration model that takes into account both company, loan related and macroeconomic variables. Next, we obtain a Value-at-Risktype (VaR) credit risk measure, by model-based simulations. Moreover, we study how both the bank's credit risk and buffer capital changes over time (had the bank been subject to the proposed rules). This approach allows us to (i) make individual forecasts of default risk conditional on company, loan and macro variables, (ii) study portfolio credit risk over time, (iii) assess to what extent the new Accord will achieve its main objective of increasing credit risk sensitivity in minimal capital charges, and (iv) compare current capital requirements to those under the proposed system. Our results show that macro conditions have great explanatory power in predicting default risk and calculating credit risk. The IRB approach, although sensitive to the choice of some horizon parameters, is an achievement in the intended direction.

- by Kasper Roszbach
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- Credit Risk, Value at Risk, Default Risk, Basel II

The aim of this paper is to use copulas functions to capture the different structures of dependency when we deal with portfolios of dependent credit risks and a basket of credit derivatives. We first present the wellknown result for the pricing of default risk, when there is only one defaultable firm. After that, we expose the structure of dependency with copulas in pricing dependent credit derivatives. Many studies suggest the inadequacy of multinormal distribution and then the failure of methods based on linear correlation for measuring the structure of dependency. Finally, we use Monte Carlo simulations for pricing Collateralized debt obligation (CDO) with Gaussian an Student copulas.

- by Fathi Abid
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- Monte Carlo Simulation, Credit Risk, Default Risk, Collateralized debt obligation

Rating agency default studies provide estimates of mean default rates over multiple time horizons but have never included estimates of the standard errors of the estimates. This is due at least in part to the challenge of accounting for the high degree of correlation induced by their cohort-based methodologies. In this paper, we present a method for estimating confidence intervals for corporate default rates derived through a bootstrapping approach. The work extends research in the academic literature on oneyear default rates ] to the multi-year horizon case. Our results indicate that historical mean speculative-grade default rates are generally measured fairly precisely, with standard errors less the 10% of the estimated means. Investment-grade default rates, however, are measured much less precisely, particularly for issuers rated single A or above. Precision increases at longer horizons. Of practical importance, the results indicate that Moody's long-term ratings satisfy the Basel II criteria for effectively distinguishing relative credit risk. This is true even for "lowdefault portfolio" portion of the rating scale -letter ratings Aaa, Aa, and single Abecause the default rates associated with these rating categories are significantly different from one another at the two-year and longer investment horizons.

- by Richard Cantor
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- Time Series, Credit Risk, Default Risk, Basel II

We implemented a randomized field experiment in Malawi examining borrower responses to being fingerprinted when applying for loans. This intervention improved the lender’s ability to implement dynamic repayment incentives, allowing it to withhold future loans from past defaulters while rewarding good borrowers with better loan terms. As predicted by a simple model, fingerprinting led to substantially higher repayment rates for borrowers with the highest ex ante default risk, but had no effect for the rest of the borrowers. We provide unique evidence that this improvement in repayment rates is accompanied by behaviors consistent with less adverse selection and lower moral hazard. (JEL D14, D82, G21, O12, O16) Imperfections in credit markets are widely seen as key barriers to growth (King and Levine 1993). Among such imperfections, asymmetric information problems play a prominent role, as they limit the ability of borrowers to commit to carrying out their obligations under debt contra...

- by Xavier Giné
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- Economics, Latin American Economic History, Adverse Selection, Moral Hazard

The pricing of bonds and bond options with default risk is analyzed in the general equilibrium model of Cox, Ingersoll, and Ross (Cir, 1985). This model is extended by means of an additional parameter in order to deal with financial and credit risk simultaneously. The estimation of such a parameter, which can be considered as the market equivalent of an agencies' bond rating, allows to extract from current quotes the market perceptions of firm's credit risk.

- by Emilio Barone and +1
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- Finance, Financial Economics, Credit Spreads, Default Risk

In this paper we investigate the contention that the model's ability to explain cross-sectional variation in equity returns occurs because the Fama-French factors, SMB and HML, are proxying for default risk. To assess the default risk hypothesis, we augment the CAPM and the Fama-French model with a default factor and run system regressions of the default enhanced models using the GMM approach. Our key findings are that: 1) default risk is not priced in equity returns; and, 2) the Fama-French factors are not proxying for default risk. Although our findings suggest that SMB and HML are not proxying for default risk, our analysis indicates that the Fama-French factors are capturing some form of priced risk. However, what type of risk the Fama-French factors are capturing remains an open question.

- by Robert Faff
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- Default Risk, Cross Section, Australian, Equity Returns

Despite a surge in the research efforts put into modeling credit and default risk during the past decade, few studies have incorporated the impact that macroeconomic conditions have on business defaults. In this paper, we estimate a duration model to explain the survival time to default for borrowers in the business loan portfolio of a major Swedish bank over the period 1994-2000. The model takes both firm-specific characteristics, such as accounting ratios and payment behaviour, loanrelated information, and the prevailing macroeconomic conditions into account. The output gap, the yield curve and consumers' expectations of future economic development have significant explanatory power for the default risk of firms. We also compare our model with a frequently used model of firm default risk that conditions only on firm-specific information. The comparison shows that while the latter model can make a reasonably accurate ranking of firms' according to default risk, our model, by taking macro conditions into account, is also able to account for the absolute level of risk.

- by Tor Jacobson
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- Applied Mathematics, Banking, Economic Development, Credit Risk
- by Marek Rutkowski
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- Default Risk
- by Marek Rutkowski
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- Default Risk
- by Kay Giesecke
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- Financial Economics, Great Depression, Developing Country, Credit Risk

This study develops a contingent-claim framework for valuing a reinsurance contract and examines how a reinsurance company can increase the value of a reinsurance contract and reduce its default risk by issuing catastrophe (CAT) bonds. The results also show how the changes in contract values and default risk premium are related to basis risk, trigger level, catastrophe risk, interest rate risk, and the reinsurer's capital position.

- by Min-teh Yu
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- Economics, Mathematical Sciences, Default Risk, Interest Rate Risk Modeling

Do hedging and speculative activity in commodity futures aect spot prices? Yes, when commodity producers have hedging needs. We build a model in which produc- ers are risk-averse to future cash ‡ow variability and hedge using futures contracts. Increases in speculative demand for futures reduces the cost of hedging, allowing pro- ducers to hedge more and hold larger inventories. This

- by Tarun Ramadorai
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- Oil and gas, Risk Aversion, Commodity prices, Default Risk

Chonsei is a unique Korean lease contract in which the tenant pays an upfront deposit, typically about 40 to 80% of the value of the property, with no requirement for periodic rent payments. At the contract maturation, the landlord then returns the nominal value of the deposit. Since there is no legal obligation on the part of the landlord to deposit the money in an escrow account, the principal default risk associated with the chonsei contract falls on the tenant. We discuss the development and popularity of this contractual agreement in the context of the public policy initiatives, historical and institutional settings surrounding the Korean housing and housing finance market. We develop a contingent-claims model that recognizes the compound options embedded in the chonsei contract. Theoretical predictions are confirmed by an empirical analysis using monthly data from 1986 to 2000. Our analysis shows that the chonsei contract is an indigenous market response to economic conditions prevalent in Korea.

- by Brent W. Ambrose
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- Real Estate, Real Estate Economics, Urban Economics, Urban And Regional Planning

1 The first version of this paper was finalised in September 2008. Comments by Patrick McGuire, Nikola Tarashev, Haibin Zhu and by seminar participants at the BIS, ECB and the Joint Bundesbank-CEPR-CFS conference on Risk Transfer: Challenges for Financial Institutions and Markets are gratefully acknowledged. The authors would also like to thank Jhuvesh Sobrun and Emir Emiray for expert help with the data. The views expressed in this paper remain those of the authors and do not necessarily reflect those of the BIS or the ECB. The usual disclaimer regarding errors and omissions applies.

- by António Afonso
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- European Union, Financial Crisis, Regression Analysis, Default Risk

This paper studies the relation between macroeconomic fluctuations and corporate defaults while conditioning on industry affiliation and an extensive set of firm-specific factors. By using a panel data set for all incorporated Swedish businesses over 1990-2002, a period which include a full-scale banking crisis and an associated deep recession followed by a prolonged economic boom, we find strong evidence for a substantial and stable impact of aggregate fluctuations on business defaults. In fact, even a logit model with financial ratios augmented with macroeconomic factors can account for the burst of business defaults during the banking crisis and low default frequency during the subsequent economic boom. Moreover, the effects of macroeconomic variables differ across industries in an economically intuitive way. Out-of-sample evaluations show our approach is superior to both models that exclude macro information and best fitting standard time-series models. While firm-specific factors are useful in ranking firms' relative riskiness, macroeconomic factors are necessary to understand fluctuations in the absolute risk level.

- by Kasper Roszbach
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- Economics, Panel Data, Microdata, Banking Crisis

Ever since the Asian Financial Crisis, concerns have risen over whether policymakers have sufficient tools to maintain financial stability. The ability to predict financial disturbances enables the authorities to take precautionary action to minimize their impact. In this context, the authorities may use any financial indicators which may accurately predict shifts in the quality of bank exposures. This paper uses key macro-economic variables (i.e. GDP growth, the inflation rate, stock prices, the exchange rates, and money in circulation) to predict the default rate of the Indonesian Islamic banks' exposures. The default rates are forecasted using the Artificial Neural Network (ANN) methodology, which incorporates the Bayesian Regularization technique. From the sensitivity analysis, it is shown that stock prices could be used as a leading indicator of future problem. . 5 Under a bank run, the depositors are paid out on a first-come-first-served basis.

- by Suprayogi suprayogi
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- Sensitivity Analysis, Islamic Banking, Applied Economics, Credit Risk

One of the principal downside risks of financial deregulation is the possible deleterious effect it may have on the incidence of mortgage arrears and possessions. Successive UK governments have enthusiastically pursued both financial deregulation and the promotion of private mortgage payment protection insurance (MPPI) as the primary safety net for mortgage borrowers. As such, the UK is an important test

- by Gwilym Pryce
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- Urban And Regional Planning, Unemployment Insurance, Default Risk, Survey data

This paper estimates the price for bearing exposure to U.S. corporate default risk during 2000-2004, based on the relationship between default probabilities, as estimated by Moody's KMV EDFs, and default swap (CDS) market rates. The default-swap data, obtained through CIBC from 39 banks and specialty dealers, allow us to establish a strong link between actual and risk-neutral default probabilities in the three sectors that we analyze: broadcasting and entertainment, healthcare, and oil and gas. We find dramatic variation over time in risk premia, from peaks in the third quarter of 2002, dropping by roughly 50% to late 2003.

- by Darrell Duffie
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- Oil and gas, Default Risk, Risk Premia

Emerging market economies typically exhibit a procyclical fiscal policy: public expenditures rise (fall) in economic expansions (recessions), whereas tax rates rise (fall) in bad (good) times. Additionally, the business cycle of these economies is characterized by countercyclical default risk. In this paper we develop a quantitative dynamic stochastic small open economy model with incomplete markets, endogenous fiscal policy and sovereign default where public expenditures and tax rates are optimally procyclical. The model also accounts for the dynamics of other key macroeconomic variables in emerging economies.

- by nurul afifah
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- Finance, Economics, Macroeconomics, Emerging Economies

Probabilistic insurance is an insurance policy involving a small probability that the consumer will not be reimbursed. Survey data suggest that people dislike probabilistic insurance and demand more than a 20% reduction in the premium to compensate for a 1% default risk. While these preferences are intuitively appealing they are difficult to reconcile with expected utility theory. Under highly plausible assumptions about the utility function, willingness to pay for probabilistic insurance should be very close to willingness to pay for standard insurance less the default risk. However, the reluctance to buy probabilistic insurance is predicted by the weighting function of prospect theory. This finding highlights the potential role of the weighting function to explain insurance.

- by Peter Wakker
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- Decision Making, Applied Economics, Prospect Theory, Default Risk