Probabilities of Default and the Market Price of Risk in a Distressed Economy
IMF Working Papers, April 1, 2011
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- Probabilities of Default and the Market Price of Risk in a Distressed Economy
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Bibliographic details
- Authors: Miguel A. Segoviano, Raphael A Espinoza
- Published: April 1, 2011
- Series: IMF Working Papers
Summary of contribution
- Proposes an original method to estimate the market price of risk under stress, needed to correct for risk aversion the CDS-implied probabilities of distress.
- Method is based, for simplicity, on a one-factor asset pricing model.
- The market price of risk under stress is defined as the expectation of the market price of risk, conditional on it exceeding a certain threshold.
- The threshold is endogenously determined so that the probability of the price of risk exceeding it is also the probability of distress of the asset.
Method and key relationships
- The market price of risk under stress is computed from:
- the price of risk (which is the variance of the market price of risk), and
- the discount factor (which is the inverse of the expected market price of risk).
- The threshold for stress is chosen endogenously so that:
- Prob(price of risk > threshold) = Prob(distress of the asset).
Estimation approaches
- The price of risk can be estimated via different methods, for instance:
- derived from the VIX, or
- from the factors in a Fama-MacBeth regression.
Subject matter and applicability
- Relevant to: Asset prices, Banking, Credit default swap, Factor models, Market risk.
- Intended to correct CDS-implied probabilities of distress by accounting for risk aversion under stressed conditions using a parsimonious one-factor framework.
IMF Working Paper by Miguel A. Segoviano and Raphael A Espinoza (April 1, 2011) — "Probabilities of Default and the Market Price of Risk in a Distressed Economy".
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- Probabilities of Default and the Market Price of Risk in a Distressed Economy