Pricing the Risks of Default

Abstract

This paper characterizes the risk neutral jump process of default in terms of two entities, i) an instantaneous arrival rate of default and ii) a conditional density of the magnitude of the proportionate reduction in the value of creditors claims. The authors propose models for default arrival and magnitude risks as functions of evolving economic information. These two default components are then explicitly priced in the futures market with the spot price of risky debt being derived as a consequence. The resulting models for default arrival and magnitude risks are estimated on monthly data for rates on certificates of deposit offered by institutions in the Savings and Loan Industry. The data period is January 1987 to December 1991. The default arrival rate is modeled as responsive to abnormal equity returns, while default magnitude risk is modeled to be sensitive to the level of core deposits and the yield on low grade bonds. The authors' empirical results for the arrival and magnitude risk models provide strong support for the hypothesis that uninsured depositors place market discipline on the depository institutions by demanding compensation for both forms of the firm's default risks.