Estimating Expected Losses and Liquidity Discounts Implicit in Debt Prices
Journal of Risk, Vol. 5, No. 1, Fall 2002
39 Pages Posted: 6 Oct 2004 Last revised: 1 Jun 2013
Date Written: November 12, 2012
This paper provides an empirical implementation of a reduced form credit risk model that incorporates both liquidity risk and correlated defaults. Liquidity risk is modeled as a convenience yield and default correlation is modeled via an intensity process that depends on market factors. Various different liquidity risk and intensity process models are investigated. Firstly, the evidence supports a non-zero liquidity premium that is firm specific, reflecting idiosyncratic and not systematic risk. Secondly, the credit risk model with correlated defaults fits the data quite well with an average R wedge 2 of .87 and a pricing error of only 1.1 percent.
Keywords: Credit Risk
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