Price of Risk - Recent Evidence from Large Financials

Abstract

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 however, the existing methods to compute PDs and generate loss estimates may vary significantly. This 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.

Keywords: Price of Risk, Risk-Neutral Probabilities, Real-World Probabilities, Cheapest-to-Deliver

JEL Classification: F3, F34, G15, K33, K41