Implied Probabilities of Default from Colombian Money Market Spreads: The Merton Model under Equity Market Informational Constraints

Borradores de Economia, Num. 743, 2012

36 Pages Posted: 24 Nov 2012

See all articles by Carlos León

Carlos León

Tilburg University - Center for Economic Research (CentER); Financial Network Analytics Ltd

Date Written: 2012

Abstract

Informational constraints may turn the Merton Model for corporate credit risk impractical. Applying this framework to the Colombian financial sector is limited to four stock-market-listed firms; more than a hundred banking and non-banking firms are not listed.

Within the same framework, firms’ debt spread over the risk-free rate may be considered as the market value of the sold put option that makes risky debt trade below default-risk-free debt. In this sense, under some supplementary but reasonable assumptions, this paper uses money market spreads implicit in sell/buy backs to infer default probabilities for local financial firms. Results comprise a richer set of (38) banking and non-banking firms. As expected, default probabilities are non-negligible, where the ratio of default-probability-to-leverage is lower for firms with access to lender-of-last-resort facilities.

The approach is valuable since it allows for inferring forward-looking default probabilities in the absence of stock prices. Yet, two issues may limit the validity of results to serial and crosssection analysis: overvaluation of default probabilities due to (i) spreads containing non-credit risk factors, and (ii) systematic undervaluation of the firm’s value. However, cross-section assessments of default probabilities within a wider range of firms are vital for financial authorities’ decision making, and represent a major improvement in the implementation of the Merton Model in absence of equity market data.

Keywords: Merton model, structural model, credit risk, probability of default, distance to default

JEL Classification: G2, G13, G33, G32

Suggested Citation

León, Carlos, Implied Probabilities of Default from Colombian Money Market Spreads: The Merton Model under Equity Market Informational Constraints (2012). Borradores de Economia, Num. 743, 2012, Available at SSRN: https://ssrn.com/abstract=2179608 or http://dx.doi.org/10.2139/ssrn.2179608

Carlos León (Contact Author)

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Financial Network Analytics Ltd ( email )

London
United Kingdom

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